16 January 2008

Northern Rock faces a slim-down, nationalised or not, in EC state aid review

Northern Rock still intends to have its strategic review ready by mid-February, in time for Brussels regulators to begin an assessment of its planned restructuring, but a lack of obvious refinancing candidates and the looming threat of nationalisation mean the continued operation of the bank in its existing form must be doubtful.

The company and its main activist shareholders appear determined to avoid a nationalisation of the bank by the government. Bryan Sanderson, the bank’s chairman, told shareholders at a special meeting in Newcastle that whatever solution emerged, the plans would have to pass though the approval process in Brussels.

The commission is for now remaining patient and clearly doesn’t want to do anything that will unduly disrupt the current rescue and restructuring process. Nevertheless, it will need to move sooner or later to ensure competition is preserved and state aid rules are applied.

And Northern Rock isn’t the only such institution the regulators are dealing with. A decision on how to proceed with the review of state aid to German Bank IKB, also a victim of the credit squeeze, is expected in the next few days.

One question that is being addressed in Brussels is to how to view a potential nationalisation in state aid terms. Nationalisation certainly isn’t the end of the story.

In the first instance, the forced purchase of shares shouldn’t over-enrich existing shareholders. Just how much existing shareholders should or could receive will be the subject of some negotiations and ultimately a legal challenge. Sanderson also stressed that wider interests in the UK, including those of the taxpayers, cannot be ignored.

Certainly, Sanderson appeared to manage down shareholder expectations when he stressed that the bank had “not received any offer that offered significant value for shareholders” and that the bank had significant obligations to the government, taxpayers and customers. Philip Richards of RAB Capital, one of the minority activist investors with a 7.5 percent stake, stressed that under nationalisation, “there won’t be much remuneration for shareholders.”

It is inconceivable that the UK government would be able and willing to pump money into the business to enable it to grow. Richards went further, claiming it was impossible. Such a move would breach state aid rules and would be open to challenge from Northern Rock competitors who haven’t benefited from the bank loans and, probably more importantly, the treasury guarantees.

Nationalisation then would result in the orderly disposal of the bank’s assets until little more than a rump regional or local bank was left. The government would be free to manage that but it is likely that an eventual sale or denationalisation would have to be figured into the equation, as intimated by UK prime minister Gordon Brown last night. “We will look at every option, and that includes taking the company into public ownership and then moving it later back into the private sector” he told ITV News at Ten.

As Sanderson stated, the bank’s assets are sound and haven’t been written down other than modest write downs of some treasury assets. Last week some 2.2 billion pounds of mortgage assets were sold at a premium to book value which serves somewhat to underline the unfortunate position the bank finds itself in.

Nevertheless the bank has struggled to refinance liabilities without the credit line extended to it by the Bank of England and continuing guarantees from the treasury.

By bank chairman Sanderson’s own admission potential lenders are looking for higher returns and more security in return for capital. The bank has been targeting institutions around the world – a process he described as thorough and painstaking – and for now with limited or no success.

There are only a small number of possible solutions – the indicative proposals from Olivant and Virgin to invest in the business as well as a possible stand-alone option and other options “at a much less developed stage.”

There will also be questions about the rate being charged Northern Rock for lending – about 100 basis points over the London Interbank Borrowing Rate – particularly given that such a rate clearly isn’t one a private investor would charge. While the bank might refer to such a rate as “penal”, the ability of the bank to grow or even survive in its current form at such lending rates may undermine that claim.

Looking at what Brussels might consider appropriate as to what a market investor would seek, it is probably more useful to look at what the commission assessed necessary when the Italian government wanted to save Alitalia – a return of about 25 percent – rather than that assessed by the commission in the Landesbanken cases where the institutions were pumped with capital but weren’t in any financial difficulties.

RAB's Richards and SRM Capital boss Jon Wood were both confident that a deal can be put together that will enable the business to continue. “Don’t assume financing won’t be in place to pay back the bank of England by the [state aid] deadline,” Wood said. SRM Global holds about 10.5 percent of the bank's shares.

Nevertheless, the Bank of England loans are only one small part of the issue at stake and the loans to the bank for the rescue package have already been declared as not state aid. The principle issue the commission will need to grapple with is the extensive loan guarantees put in place by the UK Treasury. The state aid problem is clear: Northern Rock will be competing for loan business with established banks and newcomers alike who don't benefit from such government backing.

Richards wouldn’t be drawn on the value of these guarantees. Nor would he be drawn on what returns he was seeking from his investment, or what returns outside investors could expect or would demand.

As part of the negotiations between the UK government and the commission on the restructuring of Northern Rock a significant and substantial reduction in the scope of the bank’s operations would be likely. Richards similarly declined to comment on how extensive such a reduction would need to be before he would reconsider his investment priorities in the bank.

He has however been working strenuously to prevent the break-up of Northern Rock and appears intent on keeping the business together. His motivation appears to be the asset value of the bank at around 400 pence per share compared to the current price of about 80 pence and – at a rough but educated guess – somewhere around an average 250 pence per share cost to himself. Both he and Wood stressed they are willing to put more of their own into the bank – something that will be key for the state aid review.

Much will depend on when and how much of the aid the bank is able to pay back, and what it will have to give up in return for the approval of the guarantees. The UK government has probably used up quite a lot of its political capital in Brussels in getting the European Commission’s go ahead for the rescue package and its silence while it works to get a restructuring package together.

By Robert McLeod

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