I must start this blog (like the previous one), by stating that I am a part-time Advisor to Goldman Sachs. Goldman Sachs advise the UK government on its financial strategy as regards Northern Rock, including the proposed bond issuance discussed below. I am not involved in any way with the Northern Rock-related advisory activities of Goldman Sachs, and have no inside information on these activities. This blog represents my personal views only.
The Liquidity Support Facility under which the government lends, through the Bank of England, to Northern Rock, has provided around £ 26 billion so far. In addition the government guarantee around £ 30 billion of Northern Rock deposits and other liabilities. The clock is ticking on, at least, the Liquidity Support Facility. Under EU law and rules governing state aid, this financial support will have to stop no later than the end of February 2008. Northern Rock pay a fee for the deposit guarantees offered by the government. Since we don’t know the size of this fee, or the manner in which it was determined, we cannot be sure whether there is a element of subsidy involved in the deposit guarantee also. With what I know of the history of the Northern Rock debacle, and of the main players involved, I would be staggered if there were not a significant subsidy from the tax payer to Northern Rock involved in the deposit guarantee arrangement – a subsidy that also would become illegal after February 29 under EU law on state aid. I hope that when (if?) there is a full audit of the financial transactions involving the government and Northern Rock, we will be able to uncover all the facts.
The government are about to propose an arrangement, prepared with the assistance of Goldman Sachs, for a massive extension beyond the end of February 2008, of the period for which the government will offer financial support to Northern Rock. They must believe that the proposed arrangement will not fall foul of the Brussels rules against state aid.
From what I have been able to gather from publicly available information, under the proposed arrangement, Northern Rock will issue up to £30 billion worth of bonds in the market. The bonds may have a maturity of up to 10 years and will be guaranteed by the Treasury. Northern Rock will pay a fee to the Treasury for the guarantee. The bonds issuance by Northern Rock allows it to repay some or all of the Liquidity Support Facility loans it has obtained, while leaving it with some cash with which to welcome its private sector saviours who now may be induced to come on board.
One of the reasons private rescue efforts have faltered so far, is that is was obvious that something like the financial assistance arrangements extended to Northern Rock under the Liquidity Support Facility would also have to be made available to any private sector party taking on the ownership and management of Northern Rock. Neither the Branson nor the Olivant consortium were willing to repay the government more than half its Liquidity Support Facility exposure up front. With the bond issuance, the government can be repaid not by BransOlivant or whatever consortium emerges as the buyer of Northern Rock, but by the purchasers of the new bonds issued by Northern Rock and guaranteed by the government. So the government guarantees its own repayment up front, by trading it for a longer-term exposure to Northern Rock.
This government guarantee represents a subsidy to Northern Rock, permitting the bonds to be priced as if they were Treasury debt. This is why the fee is necessary to stop the European commission from vetoing the guarantee as illegal state aid. The German Landesbanken used to benefit from a similar government guarantee on their borrowing. This was ruled illegal and the guarantees were stopped.
What is the magnitude of the subsidy inherent in the government’s guarantee of the bonds to be issued by Northern Rock? The price of a service is subsidy-free if it is not less than the marginal cost of providing the service. The marginal cost to the government of providing the guarantee is the probability of a default occurring on the bonds issued by Northern Rock and guaranteed by the government, multiplied by the amount the government will have to pay the bond holders if and when a default occurs. All this has to be thought of ‘dynamically’, that is, over a horizon of up to ten years, but the principle is clear. If the bond had a one-year maturity, the one-year probability of default were 10 percent and the recovery ratio (the fraction of the amount due that is ultimately paid by Northern Rock if and when a default takes place) 60 percent and the annual discount rate 5 percent, then a subsidy-free fee for a £30 billion loan would be £1.26 billion. For a 10-year £30 bn bond with a constant annual interest rate of 5 percent, straight-line amortisation, a constant annual default probability of 10 percent and a constant recovery ratio in the event of default of 60 percent, the subsidy-free fee for the guarantee would be £882 million. With an eighty percent recovery ratio, that number would go down to £441 million. If in addition the constant annual probability of default were only 5 percent, the figure would do down further to £262 million.
Note that the correct economic measure of the subsidy involved is not the difference between the interest rate that Northern Rock would have to pay on the bond without a government guarantee and with a government guarantee. Under current conditions that amount would probably be infinite, since Northern Rock cannot borrow long-term in the markets on any terms. The economically relevant measure of the subsidy is the difference between the marginal cost to the government of providing the guarantee and the fee charged for the guarantee. This characterisation of a subsidy-free price as one where the price of a service equals the opportunity cost of providing the service, is not simply a matter of definition. It is the appropriate measure for benchmarking a subsidy because, under quite general conditions, if a service can be provided at a this subsidy-free price, this will enhance economic welfare. Therefore, it is the natural starting point for the analysis of the conditions under which the provision of a welfare-enhancing service requires subsidies. (For more on this see Willem H. Buiter and Max Schankerman (2002), “Blended Finance and Subsidies: An Economic Analysis of the Use of Grants and Other Subsidies in Project Finance by Multilateral Development Banks”.)
There is also the question as to for how long and on what terms the government guarantee of the deposits of Northern Rock (and of assorted other Northern Rock liabilities) will be extended. If the government were to continue to provide a guarantee for, say, the next ten years, for the same amount of deposits and other credits it currently covers under its deposit guarantee, the exposure of the government would be about double the amount of the (up to) £30 bn bond that is in the works, and the subsidy-free guarantees of the total exposure would be double the amounts calculated above.
Key to any acceptable solution must be the end of government subsidies to Northern Rock. By now, the Treasury, Bank of England and the FSA must have figured out a way to quickly pay off the guaranteed depositors of Northern Rock in the event that Northern Rock goes into administration (insolvency). This could be achieved within a couple of working days, by the by the Bank of England buying the deposits from Northern Rock for cash (something that ought to make the Administrator happy) and selling them again to one or more viable private banks. With a workable scheme for preventing a bank run in place, Northern Rock has no systemic significance. Its insolvency would not threaten financial stability in the UK or elsewhere. Indeed in the longer run, the insolvency of Northern Rock would no doubt enhance the financial stability of the UK banking sector, because it would represent a stark warning against reckless funding strategies. It would be a poke in the eye for moral hazard and other perverse incentives.
Because Northern Rock is not systemically significant, there is no case for subsidising it, or for subsidising private consortia trying to purchase it. All guarantees, of both bonds and deposits, must therefore be offered at subsidy-free prices.
It is key that Parliament, the markets and all UK tax payers have full information about all the terms of the financial deal that is being struck by the government. There has been a lamentable lack of transparency thus far. There is no public information about the exact, detailed terms on which the Liquidity Support Facility is lending to Northern Rock. We also don’t know the fee Northern Rock pays for the deposit insurance granted by the government.
That lack of transparency is unnecessary and damaging to the proper functioning of the markets Northern Rock competes in. It also makes a mockery of political accountability. The extent to which the UK Parliament has become a toothless lapdog that dare not challenge its master is astonishing. Oversight without information is a joke. The government have by now acquired (deservedly) such a reputation for stonewalling with impunity request for information that ought to have been in the public domain right from the start, that Parliament often no longer even bothers to request relevant information.
It is time for the Parliamentary lapdog to get fitted with a set of canine dentures and to take a course in assertiveness training. Parliament and the public at large have the right to know by how much the government have been subsidizing Northern Rock thus far, and how much more the government plan to provide as subsidies in the future.