UK Asset Resolution, Northern Rock Asset Management, Bradford & Bingley

Most coverage of UKAR's recent results is terribly superficial and seems to miss the point, for example from the BBC:

Northern Rock Asset Management (NRAM), the so-called "bad bank" that manages Northern Rock's mortgage book, repaid £2bn of the government's loan in 2011.

But the bank still owes £19.7bn, said UK Asset Resolution (UKAR), the firm responsible for running down the bad loans of NRAM and Bradford & Bingley... UKAR as a whole - including both NRAM and Bradford & Bingley - saw profits rise to £1.1bn in 2011, up from £444.1m a year earlier.

Well done to the people at UKAR, but neither the profit nor the government loan repayment are particularly relevant in themselves, when you are looking at banks, always start off by looking at the balance sheet (taken from their 2011 results, pdf):What is striking is the speed at which they are winding down the balance sheet!

They have persuaded borrowers holding £7.5 billion's worth of mortgages to either repay or re-mortgage elsewhere (a few might have been repossessed); they have managed to offload (or realise) £5 billion of "wholesale assets" (which is presumably mortgage backed securities issued by other banks); and they have unwound net £1.7 billion of "derivative financial instruments" (whatever they are).

They used all this surplus cash and the profits of the year to repay £13.4 billion of "wholesale funding" and £2.1 billion of government funding. If it were up to me, I'd repay the government funding first, which would only take three or four years at this rate, and then hand over what's left to the "wholesale funders", but hey.

The profits of £1.4 billion or so are not actually that spectacular:Gross interest income of £2.7 billion on average total assets of over £100 billion means that the average interest rate they charge/earn is about 2.7% which is incredibly low; and the net interest margin of £1.7 billion on average assets of over £100 billion is less than two per cent (which is the historical norm), but only because their average borrowing/funding costs are laughably low at 1%.

Then you knock off £0.3 billion admin/running costs (very good value indeed) and other pluses and minuses to arrive at their pre-tax profit of £1.4 billion.

So the people at UKAR can be quietly pleased with what they have achieved - winding down the balance sheet, which is their main purpose - but maybe they could try and push up their interest rates a bit? Either borrowers will pay up (hooray) or they will re-mortgage cheaper elsewhere (hooray - because this means the balance sheet will shrink all the faster).

BTL landords: "We own land! Give us money!"

From The Daily Mail*:

The emergency ‘bank’ set up by Government to oversee the mortgages originally lent by Northern Rock and Bradford & Bingley is treating landlord borrowers unfairly, it is claimed.

A number of large borrowers allege that heavy-handed actions by UK Asset Resolution is leading to widespread tenant evictions, business failures and the sale of thousands of properties at depressed prices...(1)

But landlords claim taxpayers are losing out,(2) along with everyone else, as UKAR puts thousands of properties into receivership, fails to maintain them and ultimately sells them for less than their market value.

The allegations are difficult to prove, but growing numbers of landlords are voicing similar complaints and using popular websites such as Consumer Action Group to air them. What is not disputed is that these borrowers are stuck.

Most have little or no equity in their portfolios of property, and so cannot find another lender. On the other hand, UKAR’s objective is to get their loans off its books.

1) To whom? It strikes me that if tenants could afford to pay the rent, they could more than afford the mortgage were they to buy the home they were renting. This all helps deflate the debt bubble and increases the spread of owner-occupation. Win-win!

2) Most tenants are taxpayers, are they not? However much they lose qua taxpayer (and it will be pennies), they will be compensated ten times over if they can now buy the home they are currently renting.

* Via Taffee at HPC

If only they'd thought of this sooner!

A couple of the papers mentioned an NAO report, which praised the UK government for having saved money by buying back outstanding debt in Bradford & Bingley and Northern Rock, which is a variation on the general theme of debt-for-equity-swaps. The NAO report summarises as follows:

4.1 Over the course of 2010 Northern Rock (Asset Management) and Bradford & Bingley [after they had been taken over by the UK government] bought back £2.4 billion of their outstanding subordinated debt for £821 million in cash.

4.2 The debt was trading at substantially below its nominal value (i.e. the amount originally advanced by the investors), principally because:

a. It is not known if and when the principal and accumulated interest will eventually be paid. This makes it difficult for investors to value the debt and makes the bonds particularly unattractive to investors who seek a short-term investment.

b. Although the debt continues to accumulate suspended interest into a sum to be paid once the providers had returned all the taxpayer support, the terms of the debt do not allow interest on the interest (it is non-compound). Consequently the value of the debt and its interest falls with inflation and the money value of time.

c. There is still uncertainty regarding possible future government intervention and the potential for the Government to remove its loans, guarantees and assurances.

d. More generally, market risk remains high for the mortgage sector, and in particular there continue to be concerns about the quality of the mortgages in the mortgage providers’ books.

All good stuff, but it's a pity they didn't just do this years ago when the banks first became insolvent (in the sense that their liabilities, including bonds, exceeded the value of their assets).

Think about it:

1. By and large, the market price of the bonds would be the original principal amount minus all the potential losses of the bank (assuming share capital already wiped out).

2. So if somebody comes along and buys all the bonds and takes over the bank, that person doesn't actually lose a penny if he continues to run the bank, because the losses were all borne by the previous owners.

3. That new owner can cheerfully write down the balance sheet value of the bonds to the amount he paid for them, or convert some of the bonds into equity, it doesn't really matter. If you own all the shares and all the bonds in the bank, the total value of your holdings is much the same however you account for them.

4. As it happens, the total losses suffered by even the worst-run UK banks (B&B and NR), mainly on irrecoverable mortgages, were nowhere near as much as the amount of bonds in issue; therefore the bonds/bondholders could absorb the whole loss and the bonds always had some value (a third of their original issue price, in the above case).

5. Conversely, depositors' money was never really at risk (the UK government has always guaranteed deposits up to a certain level, it was just over £30,000 per person at the time), provided of course the government was prepared to take a firm stance and rank depositors ahead of bond holders in order of priority on a liquidation (and it is the government which writes the insolvency laws...)

6. Therefore... the government (or indeed anybody with sufficient billions to play with and the nerve to see it through) could have sorted out NR and B&B without losing a penny, or needing to actually invest any money directly into those banks, possibly even making a profit if they timed things right.

People used to tell me that I was mad to believe that you could sort out banks using debt-for-equity swaps. I think history is proving me right.

Circular Argument Of The Week - Bank Failures

From the Vote UK forum:

Pimpernal: The only way out of this banking mess is to have a bank resolution or law passed which turns the existing creditors of the banks into shareholders, whether they like it or not. At a stroke, the huge debts of banks disappear and are borne by the creditors – which they should be – and we start again. We do what the US did in the savings and loans debacle in the early 1990s: we apply a market solution to a market problem. Is there a hole in this strategy?

Richard Allen: Essentially you want widespread debt for equity swaps which is what UKIP Treasurer Mark Wadsworth has been advocating for a couple of years. The only difference is that he wouldn't mandate it by law.

Pimpernal: Does he? and how would that work if it wasn't done by legal compulsion? I guess that wouldn't be very libertarian though.

Richard Allen: You can read his many blog posts on the subject here.

Pimpernal: Hmmm it's all a bit earnest, and erm, technical to put it nicely...

Richard Allen: Well yes, but then it is a rather complex subject.
--------------------------------------
The nitty gritty is incredibly complex, but the bigger picture is dead simple - real life example showing how it would have worked with Bradford & Bingley here - what Pimpernal refers to as "a bank resolution or law passed which turns the existing creditors of the banks into shareholders" is nothing more or less than a 'debt-for-equity-swap'.

Whether this is settled by shareholder/bondholder resolutions; battled out in the insolvency courts or even done by statute (which is what Pimpernal suggested in his very first comment!) is a secondary issue; as a general rule, private resolutions are preferable to statutes, but hey.

The Trans-Atlantic Money-Go-Round

From The Metro:

Nationalised lender Bradford & Bingley said today that it was writing off more than £500 million in mortgage loans turned sour... The firm said 4.6% of its £41 billion mortgage book was three months or more in arrears, or repossessed.

I posted this over at HPC with the comment that a one per cent write down on its mortgage lending didn't seem nearly high enough. Little Professor responded by linking to this article on Bloomberg from mid-2008:

Bradford & Bingley Plc, the U.K. lender struggling to raise cash in a rights offer, must honor a 2006 deal to buy about £2.1 billion ($4.1 billion) of mortgages by the end of next year from GMAC LLC.

Customer payments are more than three months late on 5 percent of loans already purchased from Detroit-based GMAC, whose mortgage unit disclosed in a filing today it got $2.88 billion in emergency funding. That arrears rate is more than double the average for mortgages held by the Bradford & Bingley...

"This is what has spooked everybody," said Alan Beaney, who manages $2.1 billion of stocks as head of investments at Principal Investment Management in Sevenoaks, England. "They are committed to keep buying these things."

Bradford & Bingley first agreed in 2002 to buy loans from GMAC, now controlled by Cerberus Capital Management LP, the New York-based private equity firm. Steven Crawshaw, who stepped down June 1 as Bradford & Bingley's chief executive officer, formalized the deal in December 2006 and committed to buy as much as 4 billion pounds of loans a year through 2009.

It's not actually clear whether US taxpayers are now (indirectly) bailing out a UK bank or UK taxpayers are now (indirectly) bailing out a US bank, but surely this is complete and utter insanity.

Banks are not too big to fail, never have been, never will be.

CityUnslicker says in the comments to my previous post "Banks are too big to fail. If they went bust the confidence in the UK would go with it. The currency would collapse and the UK could also default on its debts."

Nope. Banks are like utilities - water, electricity, gas - they provide a vital service, but it does not matter particularly who provides that service. If a company that owns loads of power stations went bankrupt because of malinvestment and because it was overloaded with debt, the administrator would promptly sell off the power stations to somebody else, and customers wouldn't even notice a flicker.

It's no different with banks - take for example the Bradford & Bingley. One of the few masterstrokes that this government has pulled was to sell all the B&B's branches and transfer the liability to repay its customer deposits to Santander. If you were an employee of or a depositor with B&B, or the landlord of one of their branches, you wouldn't have noticed the change had you not read it in the newspapers.

This comes pretty close to the New Bank solution that CityUnslicker himself proposed a few months ago.

The mistake that the government made with the B&B was to 'nationalise' the loan book. They should have declared it a 'closed fund' and just let the shareholders and bondholders squabble over the meagre spoils, which is what I suggested after Northern Rock first went *pop* back in September 2007, which seems like ancient history somehow.

Further, our currency has already collapsed and is now bumping along the bottom, and if the government palmed off the losses onto private investors (where they belong) rather than nationalising them, the chances of "the UK defaulting on its debts" would actually be reduced.

Ah well, better luck next time. You can't expect a Labour government to have already learned the lessons of what was blindingly obvious to me a year and a half ago.

If it's good enough for us ...

From The Telegraph:

In August, the Government converted £3bn of its loan to Northern Rock into equity to bolster its core tier 1 capital ratio, which had slipped to the dangerously low level of 2.9pc. The Government may have to inject "£2bn pounds to £3bn more," into Northern Rock, a source close to the Government has told The Daily Telegraph.

Fine. In the grander scheme of things, it shouldn't make much difference in the long run whether you invest in a bank as shareholder or bondholder, and the taxpayer is both in this instance. But as I have pointed out before, debt-for-equity-swaps are the only sensible way to sorting out the banking 'crisis'. If the gummint is cheerfully swapping our loan for equity, why isn't it asking all bondholders to do the same?

This has really cheered me up (1)

I fired off a comment in response to a post at UK House Bubble titled "We need a market based solution to the credit crisis" earlier today, which Alice Cook kindly turned into a post in its own right. For posterity, I'll repeat it here:

The solution (to the banking crisis) is far simpler than that, and the State should keep out as far as possible, except to start supervising banks properly - not regulating, mind you, I mean supervising, having quiet words in ears etc.

Nobody wants to lend to banks because they are 'undercapitalised'. What does this mean in practice? It means that total liabilities are perilously close [to] total assets - especially as we know banks are overstating the value of some of their dodgier investments.

The 'capital' is just a balancing figure, really.

On the liabilities side we have customers' deposits, shorter term 'money market' stuff and longer term bonds.

To recapitalise banks, all they have to do - at gunpoint if necessary - is to cancel some of their longer term debts and replace it with share capital, a so-called 'debt-for-equity-swap'.

Hey presto, problem solved. The bondholders who get given shares can always sell their shares if they need cash - the total value of the bonds and shares, taken together, will probably be slightly enhanced by the move.

Worked example applied to Bradford & Bingley here.

As to bonuses, these are A Good Thing as far as HM Treasury is concerned - the corporation tax on negligible profits is negligible - but we know that bank managers overstated profits and then paid themselves huge bonuses taxed at effective rate 47% (including Employer's NI).

The real losers from the bonus culture are the shareholders. The problem here is that most shares are owned by 'institutions' who are in cahoots with boards of plc's and vice versa. Again, this is easily fixed - see here.

Land values can be kept low and stable by introducing land value tax (and scrapping all other property or wealth related taxes - I am a small government, low tax kind of chap).

There. All sorted.

Martin Wolf on the bank bail-outs

From today's FT:

Recapitalisation is essential if institutions are to be deemed creditworthy after the guarantees [for savers' deposits] are withdrawn. Governments should insist on a level of capitalisation that allows for further write-offs. They should then either underwrite a rights issue or purchase preference shares. Either way, governments should expect to make a profit on their investments when these institutions return to health, as they should do.

Such recapitalisation is an alternative to forced debt-to-equity swaps. I do find the latter an attractive idea. Yet today it is sure to increase the hysteria, unless it can be made credibly once-and-for-all.

"Amen!" to sensible write downs (the mark-to-market rule should apply in bad times as well as good); "Boo!" to investing taxpayers' money in badly run institutions; and "Hurray!" for debt-for-equity-swaps (the government should of course only use force to the extent that it pushes in the same direction as market forces).

As to "credible once-and-for-all forced debt-for-equity-swaps", here's how it would have worked with the Bradford & Bingley.

The best way to sort out the banking crisis - poll results

So far, the 192 responses to the question 'What's the best way to sort out the banking 'crisis'? were as follows*:

Allow them to fail - 51%
Debt-for-equity-swaps - 22%
Nationalise them - 11%
Invest taxpayers' money in new share capital - 11%
Nationalise them and then allow them to fail - 3%
Cut base rates (aka 'pushing a piece of string') - 1%
Buy up their dodgy loans for more than market value - 1%
Taxpayer funded bail-outs - 0%

A big thank you to everybody who voted; to Alice Cook who kindly featured the poll on her 'blog and to the HousepriceCrashers.

I am surprised at what a bloodthirsty bunch you are, but the clear winner is "Allow them to fail". If politicians listened to what people were saying, rather than carving out new powers for The State at their voters' expense, then any option involving taxpayers' money should be at the bottom of the list.

If banks faced the real possibility of being allowed to fail, I am sure that they would quickly come to an arrangement with their creditors (the mysterious 'money markets'), which boils down to replacing some of their the short term liabilities (money they have borrowed from the money markets, aka wholesale lending, aka bonds, aka mortgage-backed-securities) with permanent liabilities, i.e. share capital. Any sensible bondholder will always prefer to take control of the bank as a going concern, and hope to salvage something from future profits rather than force a bank into liquidation, which would merely serve to crystallise their losses with no hope of future recovery. Which is basically your second choice, "Debt-for-equity-swaps"**.

I suppose, once banks are properly recapitalised, there wouldn't be too much harm in The State taking a stake, or even nationalising them (3rd and 4th place) but once banks had done their debt-for-equity-swaps there wouldn't be any need for this.

I hope that the five people who voted for "Nationalise them and then allow them to fail" were joking***.

Finally, what is really noteworthy is that only two people voted for "Cut base rates (aka 'pushing a piece of string')", despite all the propaganda saying that rates should be cut, thanks for that!

* With hindsight, I should have included "Government guarantees for all deposits" and "Allowing banks to fudge their balance sheets" as well.

** Debt-for-equity-swaps work best if coupled with a sensible provision against bad and doubtful debts, which would be no more than 5% of mortgage advances for most UK lenders. Perhaps I should have made that clearer.

*** The gummint has nationalised Northern Rock and Bradford & Bingley and is now merrily allowing them to fail. Which is not funny.

Sorting out the Bradford & Bingley

Here's a quick summary of B&B's balance sheet, once you include a sensible ten per cent write down on all their dodgy mortgage assets:

I woke up this morning to find out that our Gummint had decided to nationalise the B&B, or as I like to call it "open up yet another Black Hole for taxpayers' finest". Had the gummint OTOH adopted the 'debt-for-equity' plan mooted by me and since adopted by Messrs Cameron & Osborne*, the balance sheet would show a healthy Tier 1 capital ratio of 13%, depositors and employees would be protected, no branches would have to be shut and all would be well with the world, as follows:


"What's the trick," I hear you gasp, "how did you do that?"

It's easy. It's called a capital reconstruction. The precise details of the legal, tax and accountancy side are devilishly complicated, but Big Picture-wise, what you do is, say to the bond holders "For every £1 face value of bonds that you hold, we will give you new bonds with a face value of 61.5p, and shares with a nominal value of 23p." Then there's a bit of netting and cancelling etc, far too arcane to go into here.

So, if you were dumb enough to originally subscribe for £1's worth of bonds issued by B&B, which had a market value of (say) 80p in the £ before the nationalisation, you would end up with shares worth 23p** and properly secured bonds worth 61.5p, so your original £1 investment is now worth 84.5p. That's a nasty 15% loss, but nothing compared to the shareholders who get more or less wiped out. Quite what the shareholders are whining about is not clear to me, as they were given these shares free on demutualisation anyway.

* My sympathies are increasingly with the Tories on this. They are being bashed for accepting donations from short-sellers in The Daily Mirror but are they being given as much credit for saying that 'reckless investors' should bear the brunt of the fall out of the credit bubble bursting rather than the taxpayer? Nope, thought not. AFAIAC, a gamble is a gamble. If you sell short and win, good for you; if you are conned into investing in 'mortgage backed securities' and you lose 15% of your money, well tough, frankly. There are worse things at sea.

** Actually, seeing as shares in Bankrupt & Bailout plc were still trading at 20p each last week, when the Better & Better plc shares are relisted, they might well be trading at 30p or 40p, in other words, the loss faced by long-term bondholders might be much less than 15%, and the original shareholders might recoup some of their losses. That's up to The Markets to decide.

UPDATE: if the B&B nationalisation was supposed to reassure the banking sector, it has failed miserably. Can we try it the old fashioned way the next time a bank fails, please?

UPDATE: and of course a reconstruction like this is not subject to EU rules against State Aid, which IMHO are an example of that rarest of things, 'Good EU rules'. The problem being that the rules are never enforced when France, Germany or Italy subsidise or protect 'national champions'. Ah well.

UPDATE: NB, comment 4, seems to be the only person over at LabourHome who has grasped this.

David Cameron's cunning plan to sort out insolvent banks

From today's interview with Andrew Marr*

Well what matters most of all is safeguarding the depositors in a bank like Bradford & Bingley. That is the absolute key. And I think what obviously is preferable is a private sale, so the business is a going concern. But I think what we've got to do in this country is get away from a situation where the only choice if you can't have a private sale is to throw the whole thing onto the taxpayer, nationalise it and have the taxpayer bearing all of that burden and bearing all of that risk...

And that is why we've been saying for a year now, because remember Northern Rock went over... went under a year ago, that we should have a situation in Britain where we have the ability for the Bank of England to take over a failing bank and to reconstruct - safeguarding the depositors and then making sure that those bits of the business that can be sold are sold. And in the end, then the bill effectively is picked up not by the taxpayer [but by the creditors]**...

So instead of nationalising [an insolvent bank], instead of the taxpayer taking all the risk, the Bank of England holds it, the Bank of England safeguards those deposits and then it works out with the business ... what bits can be sold as a going concern and what you're left with. But the key, the key at the end...the absolute key is that if at the end of that process there is a bill to be paid, the bill's paid by the creditors*** - by the banks and others that lent money to that business - and not by the taxpayer"

This method is more or less what I suggested, er, a year ago.

* Please note "The Andrew Marr Show" must be credited if any part of this transcript is used.

** Actually he said 'debtors' rather than 'creditors' at this stage, but AM kept interrupting him so we'll give him the benefit of the doubt.

*** It must be blindingly obvious that when any business goes bankrupt, shareholders get wiped out and other creditors get a pro rata share of the loss. It is vitally important at this stage to realise that there are different types of creditors. The order of priority in a liquidation is set by law, and the rules are broadly sensible. There is nothing wrong with having special rules for banks that say depositors, employees and trade creditors get priority, and that losses are borne by long-term bondholders****.

A failing bank can be sorted out even more simply and smoothly by being forced (at gunpoint if necessary) to write its mortgage receivables down to the truly recoverable amount (bearing in mind loan-to-value ratio, loan-to-income multiples, when the mortgage was originally granted and whether the borrower has ever missed a payment) and then simply replacing every £1 of long term nominal debt (that might have a market value of only 50p anyway) with a replacement debt with a face value of 50p, and compensate those bond holders by issuing them with more shares.

Hey presto, bank recapitalised - don't forget that a bank's capital is merely a balancing figure of assets (outstanding mortgages plus actual value of the business as a going concern) minus nominal debts. If you write down the book value of mortgage assets by 10% and reduce the nominal value of the debts by 50% (or whatever lesser figure might be required), all of a sudden, the bank is soundly capitalised again. We are beyond the stage of fixing this with rights issues, I don't think people will fall for that any more.

If the write-down was overcooked, then the shares that the bond holders are given will rise in value and they will recoup some of their losses.

**** There are all sorts of clever names for 'long term bonds', like 'deferred shares', 'preference shares', 'covered warrants', 'collateralised debt obligations', 'permanent interest bearing shares' and so on ad infinitum. Do not let this confuse you.

"Santander agrees A&L takeover"

Woo hoo!

When I first covered this, A&L's market cap was £2 bn, so Santander seem to have timed this right (they've offered £1.2 bn).

So, Alliance & Leicester aren't going to spoil my winning streak - unless this goes sour like the mooted Texas Pacific Group/Bradford & Bingley deal, of couse.

Update, as JonB points out "... if your combined savings in Abbey and A&L exceed £35k, you need to move some elsewhere as soon as possible."

Texas Pacific Group

Texas Pacific Group appear to be stumbling from one disaster to another.

They have pulled out of investing in Bradford & Bingley and are now thinking of investing in Taylor Wimpey at what appears to be a vastly over-inflated price (compared to its break-up value).

"Bradford & Bingley launches £300m cash call"

As I said a fortnight ago, next in line for rights issues are "Barclays, Alliance & Leicester and Bradford & Bingley".

B&B's market cap is currently £900 million, so that's a three-for-one rights issue, heady stuff indeed! OTOH, their 'total assets' were £52,000 million as at 31 December 2007, so £300 million only represents a modest 0.6%* write-down on assets. Will that be enough?

C'mon, Alliance & Leicester**, don't spoil my winning streak!

* Not 6% as I had first thought, whoops!

** Who have just written down their total assets of £79 billion by £192 million, a very modest quarter of one per cent.