Anatomy of a Deal: Northern Rock in a hard place

At 26bn and counting, the rescue of Northern Rock is the deal everyones talking about – and one you need to be up to speed with.

TIMELINE: From boom to bust

Jan 07: Northern Rock announces a pre-tax profit of 627m for 2006, up by
27 per cent on 2005.
25 July 07: Northern Rock releases very positive trading results, showing that it has sold 47 per cent more mortgages than the year before.
09 Aug 07: The global credit markets dry up following the US subprime mortgage crisis.
14 Aug 07: Bank of England (BoE) governor Mervyn King learns of the Rocks exposure to the subprime mortgage crisis in a confidential phone call with the Financial Services Authority (FSA) and the Treasury. Northern Rock had informed the FSA the day before.
4 Sept 07: Banks become wary of lending to each other, with the rate of interest charged on inter-bank loans rising to 6.8 per cent.
10 Sept 07: Lloyds TSB walks away from any takeover of Northern Rock after being refused a BoE loan of 30bn.
14 Sept 07: Northern Rocks share price plummets by 32 per cent after the the news that it had received emergency funding from the BoE breaks. Customers start queuing outside Northern Rocks branches to withdraw their savings.
17 Sept 07: To stop the first run on a UK bank in more than 140 years, Chancellor Alistair Darling guarantees all deposits at Northern Rock.
25 Sept 07: The Rock admits preliminary takeover approaches. US distressed debt fund Cerberus is mooted as one of the bidders.
8 Oct 07: Lawyer 2Bs sister publication The Lawyer breaks the story that Freshfields Bruckhaus Deringer was advising both the BoE and Northern Rock until mid-September. As a result the BoE instructs Clifford Chance.
9 Oct 07: The Treasury agrees to protect new savings at Northern Rock.
12 Oct 07: A consortium led by Virgin Group makes a rescue proposal that would see the Rock rebranded as Virgin Money. Allen & Overy is instructed.
12 Nov 07: Investment group Olivant offers another kind of proposal to take a 15 per cent stake in exchange for management control.
16 Nov 07: Eight bidders, including Virgin, Olivant, Cerberus, JC Flowers and a consortium led by Welsh businessman Alfred Goodling, submit their formal expressions of interest.
26 Nov 07: The Virgin consortium is named as the banks favoured bidder.
7 Dec 07: US private equity fund JC Flowers pulls out of the auction after making two bids.
11 Jan 08: Northern Rock sells a portfolio of mortgages worth 2.2bn to investment bank JPMorgan.
15 Jan 08: An extraordinary general meeting is called by activist hedge funds RAB Capital and SRM.
21 Jan 08: Treasury announces refinancing package based on the Goldman Sachs proposal of converting Northern Rocks BoE debt into bonds making a private sale more likely, although still at the discretion of the Treasury and the BoE.
4 Feb 08: Deadline for any parties interested in buying the Rock to submit their proposals. Olivant withdraws from auction.

The one name and one deal that has been dominating the City landscape for the past six months is Northern Rock. In any interview firms will be assessing your commercial knowledge.

Our guide to the drama surrounding Northern Rock will give you all the background you need to demonstrate your acumen.

At the beginning of last summer Northern Rock was a FTSE100 darling. But by Christmas several potential bidders for what had become the Governments biggest headache were refusing to make any further offers for the Newcastle-based lender. Several protagonists in the seemingly never ending saga have played their parts – only to make swift exits from the action. So where are we at now?

At the time of going to press just two bidders were left in the running for ‘the Rock. The first is a consortium led by Sir Richard Bransons Virgin Group, which also comprises insurance giant AIG, hedge fund Toscafund and Hong Kong-based First Eastern Investment Group. The second is an in-house team from Northern Rock. The only other credible bidder, investment group Olivant, dramatically abandoned its bid for the stricken lender just hours before deadline for interested parties to submit their bids to the Treasury.

The Virgin consortium wants to take over the bank and rebrand it as Virgin Money. Under this proposal Virgin would inject 1.25bn of fresh capital, of which 500m would be generated through a rights issue priced at 25p per share. The remaining 750m would be structured as a 500m cash injection from the consortium partners and a 250m contribution from Virgin Money.

Olivant, on the other hand, did not want to own the Rock. Rather, it proposed that its executives worked alongside the banks management in return for a 15 per cent stake. Northern Rock would get to keep its name and brand. Olivant said it would repay 15bn of the Rocks loans immediately, with the rest of the 26bn loan being repaid by 2009.

The problem is that the bidders were finding it hard to get financing for their respective offers. They still needed other banks to lend to them to pay off the debt the Rock owes the BoE. Banks are not that keen on lending any more – either in ‘paltry amounts to you or me, with mortgage and loan rates rising, or especially in the billions of pounds to other banks or institutions. This is both a cause and effect of the credit crunch (see box).

In the event of the two remaining bidders being unable to stump up the cash for their bid, the only option that might be available is to nationalise the bank. That is not ideal for many reasons: it might contravene European state aid rules (the laws that prevent governments from propping up otherwise sickly and inefficient businesses) and the taxpayer would be faced with Northern Rocks liabilities. Plus, angry shareholders might start suing.

Then there are conflict of interest issues. If it is the BoE that nationalises the Rock, would that mean the BoE can be regulated by its fellow member of the Tripartite Authorities, the Financial Services Authority (FSA)?

Chancellor Alistair Darling has said that, if he does have to nationalise the Rock, it would only be for a short period of time before it would be broken up and auctioned off. An added headache is that activist hedge funds RAB Capital and SRM, which have together amassed 18 per cent of the banks shares, called an extraordinary general meeting (EGM) on 15 January in a bid to persuade other shareholders to vote on a measure that would see Northern Rock needing to get approval to sell more than 5 per cent of its assets at any one time.

However, the funds have since softened their stance and said they are willing to work with the bank to find a private sector solution.

As recently as 11 January Northern Rock sold off a portfolio of its mortgages, worth 2.2bn, or 2 per cent of the companys assets, to investment bank and Eversheds client JPMorgan. Northern Rock is going to use the proceeds to pay off some of its loan.

Whos advising who?

Northern Rock: Freshfields Bruckhaus Deringer, Ogier (on corporate matters); Allen & Overy (on the borrowing facility from the Bank of England (BoE))
The BoE: Freshfields (until 18 September 2007), Clifford Chance (thereafter)
The Treasury: Slaughter and May
Olivant: Sullivan & Cromwell
Virgin Group-led consortium: Allen & Overy Northern Rocks creditors: Bingham McCutchen
Cerberus: Ashurst
JC Flowers: Herbert Smith
Lloyds TSB: Linklaters
RAB Capital: Nabarro
SRM: White & Case
JPMorgan: Eversheds

Also on 11 January, US investment bank Goldman Sachs, which is advising the Treasury on what to do about Northern Rock, came up with a plan that would see some of the Rocks 26bn BoE debt turned into bonds that can be sold to investors.

Sovereign wealth funds (funds that pool national assets and then invest them) particularly those in the Middle East, might want to buy these, especially if the bonds were guaranteed by the BoE in some way.

What is clear is that the Northern Rock debacle has been toxic for the UK economy. For the past decade or so, the UKs star as a capital market and as an axis for finances best and brightest has been rising. Northern Rock could wipe out that reputation. In early January Goldman Sachs issued a report that suggested betting against a fall in the pound sterling. This was all the more embarrassing because of Goldman Sachs advisory role to the Treasury.

Law firms, too, have not been immune. Setting aside for a moment the questions over conflicts of interest that have been raised (see Lawyer2B.coms feature ‘Whose Side are You On?, 14 November 2007), there has been a very real fallout. Newcastle headquartered firm Dickinson Dees, whose biggest client is Northern Rock, had to make 17 staff in its mortgages business redundant last November.

Expect a denouement in the next month or so. The BoE first threw Northern Rock a lifeline in mid-September, and a few days later the Treasury guaranteed all deposits there (see timeline).

Under state aid laws, emergency help from the Government can only be granted for six months. The one question that remains to be answered is whether the saga is a tragedy or a farce – you decide.

What do US mortgages have to do with it?

By now, you will probably have heard the throwaway phrase that Northern Rocks problems were caused by the US subprime mortgage crisis. But what does this actually mean? And how did it affect Northern Rocks business so fundamentally?

Subprime mortgages are those sold to customers with patchy credit histories and those who could not get mortgages on traditional terms from a big bank or lender. These mortgages became more popular as lenders tried to benefit from the US housing boom.

Just like assets and equity, debt can be bought and sold. So effectively what customers owed on these highrisk mortgages was packaged up and sold on by lenders as bonds to be traded by investors. These are called mortgage-backed securities.

When the US housing boom slowed in late 2006 and interest rates rose, repossessions increased of homes bought with high-risk mortgages.

Homeowners found it increasingly difficult to pay back mortgages, particularly because some of them had attractive initial rates that then ballooned a couple of years into the mortgage.

Although lenders were obviously hit by non-repayments, investors such as pension funds and investment banks that had bought these mortgage-backed securities also suffered. They could not predict the flow of money they would ultimately be getting from mortgage repayments, so the value of these securities declined. They could only sell on these bundles of debt very cheaply, and so made a loss.

Northern Rock did not risk money by buying these kinds of debt packages. Rather, it faced a ripple effect from investors that did.

Liquidity is driven by confidence and, once one obstacle blocks the pipeline of money, the whole system risks being clogged. After their recent bad experiences with mortgage backed securities, banks became wary of lending to each other and money was harder and more expensive to come by. This, in essence, is a credit crunch.

Banks retail markets are basically made up of the money that you or I deposit into our accounts. Rather than using a simple money in equals money out business model based on retail deposits, the loans made by Northern Rock relied on the wholesale markets where banks lend to each other.

This model works well in times of high liquidity and means mortgages can be offered at cheaper rates. But it is riskier.

Like the models we have seen above, Northern Rock also bundled up debt it was owed on future mortgages – even if they were not of the subprime variety – and sold them on as bonds. The core business of Northern Rock, which has fewer branches than competitors where customers can make deposits, was offering mortgages. But to have the money to loan in the first place the bank needed money coming in as proceeds from selling its mortgage backed securities.

The problem for Northern Rock is that, after the subprime crisis in the US, its bonds based on mortgages were highly unattractive. Investors ran a mile from anything to do with mortgages. This meant Northern Rock could not predict from where its flow of money coming in was going to arrive. The only loans it could get were at interest rates a lot higher than it could offer mortgages at. The only option was to to ask the Bank of England for emergency assistance as the lender of last resort.