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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The Treasury's proposals to provide funding for private sector bids for Northern Rock (announced here) look something like this:

• billions of £s of the Rock's assets (mortgage loans etc) would be sold to a special purpose vehicle;
• the SPV would issue bonds, secured on the assets and guaranteed by the Treasury (ie the taxpayer), raising say, £30bn;
• the money raised from the bonds would be paid to Northern Rock (to buy the assets moved into the SPV);
• Northern Rock would repay the loans it has had from the Bank of England.

Staightforward so far - the assets and liabilities are taken off Northern Rock's books and the Bank of England loans are turned into government guarantees. The securitisation does look suspiciously like the CDOs we have seen suffering in the capital markets in recent months, but at least the bonds will be gilt-edged.

There is more:

• to ensure the bonds are fully secured and to reduce the risk to the taxpayer if asset values fall (eg if residential property values fall or loan arrears rise) - in other words, to keep the SPV solvent - the value of assets transferred from the Rock will be more than the amount raised from the bonds and the difference will be a loan to the SPV from Northern Rock;
• Northern Rock will also provide the Treasury with a guarantee, secured on its remaining assets;
• Northern Rock has to raise additional equity capital and the Treasury will have an equity stake.

Not terribly appealing requirements for Virgin, Olivant et al.

If the SPV were to go bust, the Treasury would have recourse to the net assets of Northern Rock. How much would they be worth? It's difficult to say, but it's not hard to imagine them being exhausted if market conditions are such that the SPV has failed. But remember the shareholders' capital will be very much less than the value of the government guarantee.

It's the taxpayer who pays the bondholders if everything goes wrong.

If everything goes right, what happens?

• The Treasury is paid fees for its guarantees, which are released over a period of, say, 5 years; and
  
• Northern Rock's shareholders take the profits.

The negotiations will be fascinating. Despite the government's reminders that nationalisation remains an option, it is clearly politically unattractive. How much of an equity stake will the Treasury be able to persuade the private sector bidders it should have? Will the Treasury's upside return properly reward its downside risk?

Robert Peston implies here that a successful private sector bid is not a foregone conclusion.

Would the Lloyds TSB deal on offer in early September have meant less cost and risk for taxpayers? Even the Treasury Select Committee isn't sure (see our post on their conclusions here), but they did suggest that this restructuring lacked a key ingredient - early decisive action.

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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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