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 amnot 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 viewsonly.
The Liquidity Support Facility under which the governmentlends, through the Bank of England, to Northern Rock, has provided around £ 26billion so far. In addition thegovernment guarantee around £ 30 billion of Northern Rock deposits and other liabilities. The clock is ticking on, at least, theLiquidity Support Facility. Under EU lawand rules governing state aid, this financial support will have to stop nolater than the end of February 2008. Northern Rock pay a fee for the deposit guarantees offered by thegovernment. Since we don’t know the size of this fee, or the manner in which itwas determined, we cannot be sure whether there is a element of subsidyinvolved in the deposit guarantee also. Withwhat I know of the history of the Northern Rock debacle, and of the mainplayers involved, I would be staggered if there were not a significant subsidyfrom the tax payer to Northern Rock involved in the deposit guaranteearrangement – a subsidy that also would become illegal after February 29 underEU law on state aid. I hope that when(if?) there is a full audit of the financial transactions involving thegovernment and Northern Rock, we will be able to uncover all the facts.
The government are about to propose an arrangement, preparedwith the assistance of Goldman Sachs, for a massive extension beyond the end ofFebruary 2008, of the period for which the government will offer financialsupport to Northern Rock. They mustbelieve 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 availableinformation, under the proposed arrangement, Northern Rock will issue up to £30billion worth of bonds in the market. The bonds may have a maturity of up to 10 years and will be guaranteedby the Treasury. Northern Rock will paya fee to the Treasury for the guarantee. The bonds issuance by Northern Rock allows it to repay some or all ofthe Liquidity Support Facility loans it has obtained, while leaving it withsome cash with which to welcome its private sector saviours who now may beinduced to come on board.
One of the reasons private rescue efforts have faltered sofar, is that is was obvious that something like the financial assistancearrangements extended to Northern Rock under the Liquidity Support Facilitywould also have to be made available to any private sector party taking on theownership and management of Northern Rock. Neither the Branson nor the Olivant consortium were willing to repay thegovernment more than half its Liquidity Support Facility exposure up front.With the bond issuance, the government can be repaid not by BransOlivant orwhatever consortium emerges as the buyer of Northern Rock, but by thepurchasers of the new bonds issued by Northern Rock and guaranteed by thegovernment. So the government guaranteesits own repayment up front, by trading it for a longer-term exposure toNorthern Rock.
This government guarantee represents a subsidy to NorthernRock, permitting the bonds to be priced as if they were Treasury debt. This is why the fee is necessary to stop theEuropean commission from vetoing the guarantee as illegal state aid. The German Landesbanken used to benefit froma similar government guarantee on their borrowing. This was ruled illegal and the guaranteeswere stopped.
What is the magnitude of the subsidy inherent in thegovernment’s guarantee of the bonds to be issued by Northern Rock? The price of a service is subsidy-free if itis not less than the marginal cost of providing the service. The marginal cost to the government ofproviding the guarantee is the probability of a default occurring on the bondsissued by Northern Rock and guaranteed by the government, multiplied by theamount the government will have to pay the bond holders if and when a defaultoccurs. All this has to be thought of‘dynamically’, that is, over a horizon of up to ten years, but the principle isclear. If the bond had a one-yearmaturity, the one-year probability of default were 10 percent and the recoveryratio (the fraction of the amount due that is ultimately paid by Northern Rock ifand when a default takes place) 60 percent and the annual discount rate 5percent, then a subsidy-free fee for a £30 billion loan would be £1.26 billion. For a 10-year £30 bn bond with a constantannual interest rate of 5 percent, straight-line amortisation, a constantannual default probability of 10 percent and a constant recovery ratio in theevent of default of 60 percent, the subsidy-free fee for the guarantee would be£882 million. With an eighty percentrecovery ratio, that number would go down to £441 million. If in addition the constant annualprobability of default were only 5 percent, the figure would do down further to£262 million.
Notethat the correct economic measure of the subsidy involved is not the differencebetween the interest rate that Northern Rock would have to pay on the bondwithout a government guarantee and with a government guarantee. Under current conditions that amount wouldprobably be infinite, since Northern Rock cannot borrow long-term in themarkets on any terms. The economicallyrelevant measure of the subsidy is the difference between the marginal cost tothe government of providing the guarantee and the fee charged for the guarantee. This characterisation of a subsidy-free price as one where theprice of a service equals the opportunity cost of providing the service, is notsimply a matter of definition. It is theappropriate measure for benchmarking a subsidy because, under quite generalconditions, if a service can be provided at a this subsidy-freeprice, this will enhance economic welfare. Therefore, it is the naturalstarting point for the analysis of the conditions under which the provision ofa welfare-enhancing service requires subsidies. (For more on this see WillemH. Buiter and Max Schankerman (2002), “BlendedFinance and Subsidies: An Economic Analysis of the Use of Grants and OtherSubsidies in Project Finance by Multilateral Development Banks”.)
There is also the question as to for how long and on whatterms the government guarantee of the deposits of Northern Rock (and ofassorted other Northern Rock liabilities) will be extended. If the government were to continue toprovide a guarantee for, say, the next ten years, for the same amount of deposits and othercredits it currently covers under its deposit guarantee, the exposure of thegovernment would be about double the amount of the (up to) £30 bn bond that isin the works, and the subsidy-free guarantees of the total exposure would bedouble the amounts calculated above.
Key to any acceptable solution must be the end of governmentsubsidies to Northern Rock. By now, theTreasury, Bank of England and the FSA must have figured out a way to quicklypay off the guaranteed depositors of Northern Rock in the event that NorthernRock goes into administration (insolvency). This could be achieved within a couple of working days, by the by theBank of England buying the deposits from Northern Rock for cash (something thatought to make the Administrator happy) and selling them again to one or moreviable private banks. With a workablescheme for preventing a bank run in place, Northern Rock has no systemicsignificance. Its insolvency would notthreaten financial stability in the UK or elsewhere. Indeed in the longer run,the insolvency of Northern Rock would no doubt enhance the financial stabilityof the UK banking sector, because it would represent a stark warning against recklessfunding strategies. It would be a pokein the eye for moral hazard and other perverse incentives.
Because Northern Rock is not systemically significant, thereis no case for subsidising it, or for subsidising private consortia trying topurchase it. All guarantees, of bothbonds 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 thatis being struck by the government. Therehas 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 NorthernRock. We also don’t know the feeNorthern Rock pays for the deposit insurance granted by the government.
That lack of transparency is unnecessary and damaging to theproper functioning of the markets Northern Rock competes in. It also makes a mockery of politicalaccountability. The extent to which theUK Parliament has become a toothless lapdog that dare not challenge its masteris astonishing. Oversight withoutinformation is a joke. The governmenthave by now acquired (deservedly) such a reputation for stonewalling withimpunity request for information that ought to have been in the public domainright from the start, that Parliament often no longer even bothers to requestrelevant information.
It is time for the Parliamentary lapdog to get fitted with aset of canine dentures and to take a course in assertiveness training. Parliament and the public at large have theright to know by how much the government have been subsidizing Northern Rockthus far, and how much more the government plan to provide as subsidies in the future.