The Chancellor has announced (notably without using the n-word) that Northern Rock is to be nationalised.

What does this mean?

• The shares pass into public ownership
• The government has at last called the bluff of the hedge fund shareholders
• Ron Sandler becomes Executive Chairman
• Focus should now be brought to restructuring the business to create - in several months' time - something saleable

It will be difficult for the government to avoid the charge of dither and delay. As reported in our previous post, the Treasury Select Committee has made clear that early decisive action was the missing ingredient in this restructuring.

Although the company should now be able to concentrate on turning itself around, the government - as the new owner - should steer clear of micromanagement. Mr Sandler and his team should be left to manage the business, and the government should concentrate on the politics (and the arguments with shareholders about compensation).

At least the risk of formal insolvency has receded almost entirely - it's just not necessary with the Treasury as both senior lender and shareholder. The balance sheet has been restructured through a form of debt-for-equity deal. One could also describe nationalisation in this case as a form of administration or receivership but without the stigma of insolvency and with only shareholders being crammed down. Indeed, had the government not guaranteed all the depositors, Northern Rock would have been in a similar position to other companies with administration being the mechanism used to restructure the balance sheet.

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Headlines and commentary abound, but the real thing (181 pages) is here (pdf) or  here (html).

It stretches from mention of previous bank runs (Overend, Gurney & Co., 1866;  City of Glasgow Bank, 1878), Barings' liquidity crisis and the liquidation of BCCI to a detailed analysis of the development of the Northern Rock crisis in August and September 2007.

The conclusions (quick link here) highlight firmly the responsibility of Northern Rock's directors for the reckless business model - borrowing short and lending long - which collapsed with the credit crunch, for failing to ensure that the bank remained liquid as well as solvent, and for failing to provide against the risks they were taking.

But they are also highly critical of the FSA:

• "substantial failure of regulation."
• "it was wrong of the FSA to allow Northern Rock to weaken its balance sheet at a time when the FSA was itself concerned about problems of liquidity that could affect the financial sector."
• "The current regulatory regime for the liquidity of United Kingdom banks is flawed."
• "It was the responsibility of the Financial Services Authority to ensure that the work of the Board of Northern Rock was sufficient to the task. The Financial Services Authority failed in its duty to do this."
• "The Financial Services Authority should not have allowed nor ever again allow the two appointments of a Chairman and a Chief Executive to a "high-impact" financial institution where both candidates lack relevant financial qualifications"
• "The FSA did not supervise Northern Rock properly. It did not allocate sufficient resources or time to monitoring a bank whose business model was so clearly an outlier; its procedures were inadequate to supervise a bank whose business grew so rapidly. We are concerned about the lack of resources within the Financial Services Authority solely charged to the direct supervision of Northern Rock. The failure of Northern Rock, while a failure of its own Board, was also a failure of its regulator."
• "In the case of Northern Rock, the FSA appears to have systematically failed in its duty as a regulator to ensure Northern Rock would not pose such a systemic risk, and this failure contributed significantly to the difficulties, and risks to the public purse, that have followed."

The Bank of England gets off relatively lightly with recommendations as to its response but few direct criticisms:

• "We are unconvinced that the Bank of England's focus on moral hazard was appropriate for the circumstances in August. In our view, the lack of confidence in the money markets was a practical problem and the Bank of England should have adopted a more proactive response."
• "we have concluded that the Bank of England should have broadened the range of acceptable collateral at an earlier stage in the turmoil."

The report's conclusions about the Chancellor's role are somewhat more opaque:

•  "State support for Northern Rock has involved the Government entering into contingent liabilities on a very large scale. It is important that the Treasury discharges its obligations to the House of Commons—and through the House of Commons to the taxpayer—promptly and fully to report on the extent of such liabilities."
• "We cannot accept, as some witnesses have suggested, that the Tripartite system operated "well" in this crisis. In terms of information exchange between the Tripartite authorities, the system might have ensured that all the Tripartite authorities were fully informed. However, for a run on a bank to have occurred in the United Kingdom is unacceptable, and represents a significant failure of the Tripartite system. If the system worked so "well", the Tripartite authorities should take a closer look at the people side of the operation."
• "While we welcome the Chancellor's admission that he was ultimately in charge of the decision making process relating to Northern Rock, we are concerned that, to outside observers, the Tripartite authorities did not seem to have a clear leadership structure."
• It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility."
• "We are also concerned that it did not prove possible to announce the guarantee that was decided upon that day before the markets opened the following day. The cumulative effect of these failures was to delay the guarantee until the evening of the fourth day after the run started and thus to make the run on the deposits of Northern Rock more prolonged, and more damaging to the health of the company, than might otherwise have been the case."
• "In view of the role that fears of a leak of a support operation had played in the decision on Tuesday 11 September that a covert operation was not possible, the Tripartite authorities were unwise initially to accede to Northern Rock's request for the announcement of the support operation to be delayed until Monday 17 September. In the light of subsequent events, it seems evident that the Tripartite authorities and Northern Rock ought to have strained every sinew to finalise the support operation and announce it within hours rather than days of the decision to proceed with the operation."
• "In failing either to make an announcement earlier in the week or to put in place adequate plans for handling press and public interest in the support operation, the Tripartite authorities and the Board of Northern Rock ended up with the worst of both worlds."

It will be interesting to see whether the Committee's recommendations for regulatory reform are followed, given the Chancellor's slightly different proposals aired last week.

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Here's a view on the UK's economic outlook from Howard Reed, Chief Economist at the Institute for Public Policy Research, published in the New Statesman: Was Northern Rock the worst of it?

Despite huge stock market falls in the last two days, the balance of comment still appears to be that the underlying UK economy is in reasonable shape and whilst we can expect further tightening a recession is not on the cards.

Reports following analysis of January's Monetary Policy Committee minutes at Bloomberg and Channel 4 News illustrate current thinking (although the latter notes that George Soros, billionaire investor, disagrees. . . ).

No recession, I agree, but we certainly haven't seen the worst of the turbulence. In the business world I think there are many who have not yet come to terms with either the dramatic change in lenders' appetites or the effect the turbulence has had on consumer sentiment.

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The Northern Rock crisis has prompted Alistair Darling, Chancellor of the Exchequer, to announce proposals for a special insolvency regime for banks in the UK. Following the publication of a consultation paper in October 2007, “Banking reform – protecting depositors”, and consideration of its results, the Chancellor revealed in an interview with the Financial Times, reported here on 3 January, some hints about his intentions.

Details are patchy – perhaps deliberately – with the Chancellor planning to release more information to the Treasury Select Committee on Thursday 10 January.

It seems that the FSA (Financial Services Authority) would have a role to step in at the beginning of one or more “trigger events” such as the provision of emergency funding by the Bank of England.

A debatable observation from the Chancellor was that “Insolvency laws make it actually quite difficult to move quickly if you need to take action”. He also appeared to criticise the US system, where he said a healthy bank could find itself being restructured, while he suggested that there may be ideas worth following in the Canadian and Belgian systems.

What special insolvency regime does your experience suggest will work for banks?

 

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The credit crunch of August-September 2007 has disturbed the economic equilibrium - and may continue for a while yet. Debates about illiquidity or insolvency abound, but are we really facing a swing from boom to bust?

The underlying UK economy is strong, but we now have corporate transactions stalling through lack of funding, hedge fund failures, a sub-prime lender in administration and the Northern Rock bailout. What many considered a strange US phenomenon (had many people heard of sub-prime before this summer?) has become a real domestic issue. No wonder business and consumer sentiment is waning:

• the ICAEW UK Business Confidence Monitor (BCM) has moderated in Q3 2007 from a Q2 peak of +11.5 to a relatively weak +4.8;
• the BDO Optimism Index shows a sharp fall in August, from 101.9 to 101.2, confirming the impact of the US sub-prime crisis on UK businesses. This drop takes the Index to its lowest score since November 2005 and whilst business optimism has been decreasing slowly since July 2006, it appears that the impact of the turbulent financial markets has accelerated this trend; and
• the Nationwide Consumer Confidence Index fell back in August reflecting the impact of five interest rate rises over the past year. The main Index fell by two points, but it was not alone. All indices fell in August, the first time since December 2006 that all four measures of confidence showed a downturn in the same month.

For a reminder of how the credit crunch derived from the US sub-prime contagion via risk reappraisal amongst lenders and hedge funds, how CDOs, CLOs and SIV-lites were ideal vectors to spread the disease around the world, and the impact on bank lending, read "While you were away - fear and loathing in the markets" from The Times.

Other recent indications of the state and direction of the economy are:

• US business bankruptcies are on the rise, reports Bob Eisenbach, quoting Euler Hermes, who continued to forecast a small rise in the UK. After we reported Euler's November '06 forecast in a previous post, Geoff Swire commented when the UK's June insolvency figures became available that the forecast had been pessimistic. I suspect it was a timing issue and that corporate insolvency statistics in Q3 will rise in the UK, albeit by less than in the US.
• The world has changed dramatically: Germany’s Chamber of Industry has been flooded with distress calls from family Mittlestand firms unable to roll over credit lines and in Canada and Australia, junior mining finance has dried up almost entirely, according to Ambrose Evans-Pritchard on his Telegraph blog post "Brace yourself for the insolvency crunch".
• If the liquidity crisis continues it will will become an insolvency crisis and the banking industry will be hardest hit, according to Panmure Gordon.
• Insolvency firms are likely to be busy dismantling failed investment vehicles, with the most likely suspects being the quantitative hedge funds and funds focused on CDOs that have fallen foul of market conditions, writes Antonia Rawlinson "Uncertain times call for certain measures" in The Lawyer.
• "The M&A boom is over and law firms must adapt" agrees James Rossiter in The Times - restructuring is now the hottest game in town.

So what does all this mean? Yes the capital markets are in turmoil, banks are lending much more cautiously and some high risk investment vehicles are failing, but essentially this is only a liquidity problem. Its effect though is that stressed businesses will no longer be able to borrow their way out of trouble as they have become hard-wired to do over the last 3 years.

Crisis cash management and operational and corporate restructuring will come back into vogue as refinancing becomes passé. Only if stressed businesses fail to seek appropriate and timely assistance will the business insolvency statistics really start to rise.

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Was the Bank of England's bail-out of Nothern Rock, Britain's 5th largest mortgage lender justified on the grounds that it met Mervyn King's parameters explained recently in a letter to the Treasury Select Committee?

". . .central banks, in their traditional lender of last resort (LOLR) role, can lend
“against good collateral at a penalty rate” to an individual bank facing temporary
liquidity problems, but that is otherwise regarded as solvent."

Professor Willem Buiter of the LSE, formerly a member of the MPC, believes the Bank is proven to be a paper tiger. Firstly his blog notes (here) Northern Rock's "extremely agressive and high risk" business strategy and that its share price was declining steeply well before the credit crunch in recognition of an absence of long term viability.

Adam Applegarth, Northern Rock's chief executive is quoted by the Times on 15 September 2007acknowledging a flawed model (here): “Is the model flawed looking foward? Of course it is. Is it flawed looking back? I think the answer is no because of the markets that we were operating in prior to August 9".

Mervyn King's letter also stated:

"The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England."

Professor Buiter quotes the Memorandum of Understanding:

"Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy.”

and argues that if Northern Rock were to fail it would neither threaten the stability of the UK financial system nor seriously disturb the economy.

According to the Times article, two white knights have walked away from rescuing Northern Rock.

But despite reports of savers queing to withdraw £1bn today, the BBC's story "What if Northern Rock goes bust?" shouldn't become reality. The Old Lady of Threadneedle Street has stepped in as Lender of Last Resort.

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