Category: Money Moves Markets

Northern Rock could be in a position to repay most its loan from the Bank of England by early next year. Here’s how.

First, consider the Granite securitisation vehicle. According to documentation on Rock’s website, on 31 March 2007 Granite held £16 billion worth of fixed-rate mortgages with resets occurring in 2008. Rock is offering unattractive rates to refinance, while its standard variable rate is a high 7.59%. Any borrowers able to switch to other mortgage lenders are likely to do so. Let’s assume £13 billion of Granite mortgages are repaid in 2008.

Granite expects to repay principal of £9 billion on its outstanding notes in 2008. If £13 billion flows back from mortgages, this leaves a surplus of £4 billion. My understanding is that Northern Rock is able to extract this surplus by injecting mortgages from its own book into the Granite pool.

Rock’s non-Granite mortgages totalled £38 billion on 30 June 2007 so there would seem to be no obstacle to extracting surplus cash from Granite, even if new mortgage business is negligible, as seems likely. Moreover, a portion of these non-Granite mortgages will also be repaid this year. Assuming the same profile as for the Granite pool, £11 billion could be fixed-rate deals resetting in 2008. Let’s say £9 billion of non-Granite mortgages are repaid this year. Adding this to the £4 billion Granite surplus gives a total inflow of £13 billion.

Now consider funding. Rock had £24 billion of retail deposits on 30 June 2007 but at least half left the bank after it was forced to seek emergency funding from the Bank of England. Post-nationalisation, savings are returning in response to high interest rates and the unlimited government guarantee. (Savers were previously deterred by the risk of accounts being frozen if the bank entered administration.) Even after a recent cut, Rock’s tracker online and silver savings accounts offer a highly competitive 6.25%. If this edge is maintained, retail inflows of £10 billion or more look possible this year. (Landsbanki’s ICESAVE attracted £5 billion in the 15 months to 31 December 2007 from a standing start and without the benefit of a government guarantee.)

Adding a £10 billion deposit inflow to mortgage repayments of £13 billion would leave Rock only £2 billion short of the estimated £25 billion Bank of England loan.

What could go wrong with this scenario? One risk is that other lenders will be unable to accommodate borrowers switching from Rock given the current difficult funding environment. Perhaps this partly explains government measures announced last week designed to restart the market for mortgage securities.

Similarly, concerns about unfair competition or the stability of other institutions relying on retail funding may force Rock to cut its deposit rates, implying a smaller savings inflow.

Rock could also decide not to pay the Bank of England back so soon, even if it has the resources. It may wish to continue to generate new mortgage business, albeit on a much smaller scale than in recent years, in order to maximise its attraction to an eventual purchaser. Also, the Bank loan represents cheap funding, at least when considered from the perspective of the public sector as a whole. The Bank of England effectively pays Bank rate on the money it creates to lend to Rock. At 5.25%, this is a full percentage point below the rates Rock currently offers on its leading savings products.

Friday’s weak payrolls numbers are widely viewed as confirming that the US economy is in a recession. I think they are consistent with a flat economy. A recession may be coming but it has yet to be confirmed.

A recessionary labour market is characterised by a fall in hiring and a rise in layoffs. So far only the former has occurred. Layoff announcements have been stable in recent months – see chart. This is why weekly initial claims for unemployment insurance have yet to reach the 400,000 level that would signal a recession.

Interestingly, Manpower chairman and chief executive Jeffrey A. Joerres made the same point when commenting on his firm’s latest hiring survey, showing the weakest US jobs outlook for four years. “The important change is not about reductions in workforces, like we would expect in a recessionary period, but rather an increase in the percentages of employers who are planning to put a hold on hiring.”

According to the payrolls report, aggregate weekly hours worked in the private nonfarm economy contracted at a 1.7% annualised rate in January / February from the fourth quarter. This could still be consistent with stable or expanding output, given that productivity has recently been growing at a 2% pace.

The worsening credit crisis and soaring food and energy costs have increased near-term risks but there is substantial monetary and fiscal stimulus in the pipeline. The economy may yet muddle through. Wait for layoffs and initial claims to rise before accepting recession orthodoxy.

An earlier post argued that damage to US financial institutions from the subprime crisis could be similar in scale to the losses suffered as a result of the savings and loan crisis of the late 1980s. If so, the fall in financial stocks in 1989-90 could be a guide to the extent of the current bear market.

At the time of the last post the comparison suggested the bear market would extend in both price and time but a bottom might be in place by March, to be followed by a strong rally over the remainder of the year. The chart below provides an update. Financial stocks would have to fall by a further 10% to match the cumulative decline during the S&L bear market but are now in the time window for a low.

Bears argue that valuations are not yet as depressed as at the October 1990 trough. For example, the price to book ratio of the financials index is 1.46 versus 1.02 then. Relative to other sectors, however, the position is more extreme now: the price to book discount to non-financials is 52% versus 45% at the 1990 low.

Another bear argument is that loan delinquencies will rise further but that was also true when the October 1990 rally began: delinquencies peaked in the second half of 1991, by which time financial stocks had rallied by more than 60%.

The real level of the Fed funds rate is lower now than at the 1990 trough, while the Treasury yield curve is steeper. Credit spreads are still widening but they were at the time of the 1990 rally too, peaking only three months later.

Perhaps subprime losses will exceed S&L damage. If not, financials are starting to look attractive, particularly relative to other sectors.

My monetary policy models indicate the MPC should have cut rates yesterday while the ECB should have signalled an easing bias. The intransigence of the two central banks despite mounting economic risks from credit market deterioration and a sinking dollar threatens to push markets to a “riot point”.

As others have noted, there are similarities with events preceding the October 1987 stock market crash, when the Bundesbank defied an international effort to support the dollar by raising interest rates in response to an oil-induced rise in inflation. While the ECB and MPC were on hold yesterday, interbank rates have been climbing.

Stock markets have been sliding rather than plunging but credit markets have already crashed. On one measure of the yield spread of sterling corporate bonds over gilts, the rise over the last six weeks represents a four-standard-deviation event.

I still think a hard economic landing is avoidable and plentiful liquidity will limit stock market damage but central banks are increasing the risks. The Fed is as much to blame, with its panic cuts serving mainly to undermine the dollar and inflate a commodity bubble. There is a strong case for coordinated policy action, with the Fed holding US rates at current levels and the ECB and other major central banks easing. Markets may force such action if it does not occur voluntarily.

A rate cut was needed to offset the negative economic impact of the significant deterioration in credit markets over the last month. Rising inflation reflects surging commodity prices, over which the MPC has no influence. Wage settlements remain stable and are unlikely to pick up against the backdrop of a cooling labour market. The MPC’s failure to act today increases the risk of serious economic weakness and an eventual inflation undershoot.

The MPC-ometer was wrong this month. The last miss was in June last year, when a quarter-point rise was predicted. Subsequent minutes revealed a 5-4 split and rates moved as forecast a month later.

My suggestion of a surprise rate cut tomorrow looks less likely following today’s strong services purchasing managers’ survey for February. The business activity index rebounded to a five-month high, while prices charged surged to a new record.

The case for a reduction rests on credit market deterioration since the last MPC meeting. Three-month LIBOR has risen from 5.58% before the February rate cut to 5.77% currently, while the yield spread of A-rated sterling bonds over gilts has climbed 48 bp, reaching its highest level since before the early 1990s recession. These changes imply the economy faces increasing financial headwinds despite last month’s policy move.

Incorporating the services PMI results, the MPC-ometer rates the chances of a cut tomorrow at exactly 50%. It continues to suggest a high probability of a reduction by April.

The purchasing managers’ survey is strangely at odds with the CBI / Grant Thornton survey of consumer and business services, also published today. The CBI survey reported a sharp drop in expected business volumes and a reduction in price expectations. As the charts below show, the two surveys normally correlate closely, raising the possibility that this month’s PMI improvement will prove a blip.

My MPC-ometer model is forecasting an "average interest rate recommendation" of -13 bp at this week’s MPC meeting – just beyond the 12.5 bp threshold, suggesting a 5-4 vote for a 25 bp cut.

A week ago, the model was pointing to a 6-3 majority for unchanged rates. The swing factors over the last couple of days have been weak February consumer confidence results and a further deterioration in credit markets.

One missing input is the purchasing managers’ services survey, released on Wednesday. Any weakness relative to last month’s results would obviously boost the chances of a cut.

This could be one of those occasions (such as June last year) when the model is a month early. Its historical performance in backtests is 90%; of the 10% of misses, half have been due to the model predicting a change one month in advance.

Another cut this month would sit uneasily with MPC communications indicating concern that the coming rise in inflation will further destabilise expectations. However, MPC members have also stressed the risks posed by tighter credit conditions. Credit spreads have widened significantly further since their last meeting, in some cases reaching the highest level since before the early 1990s recession. Three-month LIBOR has also been firming – it was set at 5.74% on Friday, far above Bank rate of 5.25%.

For comparison, the Sunday Times Shadow MPC voted 7-2 to leave rates unchanged this month.

Media comment has focused on the risks but the nationalisation of Northern Rock could prove extraordinarily profitable for UK taxpayers – assuming the government can avoid making a significant compensation payment to equity and subordinated debt holders.

Despite Treasury guarantees, Northern Rock has been forced to offer high interest rates to retain its retail deposit base, with savers concerned that their accounts would be frozen in the event of the bank going into administration. (Including a temporary loyalty bonus, Rock’s tracker online account currently pays a 6.99% AER.) Nationalisation removes this liquidity risk and should allow the bank to reduce its retail funding costs significantly.

European Union state aid requirements imply the Bank of England will continue to charge a penal interest rate on its loan but this now represents a transfer within the public sector.

On the assets side, the aim will be to shrink the mortgage book to allow early repayment of the Bank of England’s loan. New lending will be negligible and mortgage rates will be raised to encourage existing borrowers to refinance elsewhere. Assuming they stay, this will add to the boost to profitability from lower funding costs. Job losses are also inevitable, reducing the bank’s cost base.

The key concern is that housing market weakness coupled with possible adverse incentive effects from public ownership will lead to significant default losses. Northern Rock had £97 billion of customer loans at 30 June 2007 but credit risk on £46 billion of the total had been partially transferred to holders of securitised notes.

In the housing recession of the early 1990s repossessions nationally reached a peak of 0.77% of outstanding mortgages in 1991. Assume Northern Rock is forced to foreclose on 1% of its loans each year for three years and achieves a recovery rate of only 70%. Based on a £97 billion book, this would imply a loss of £850-900 million, of which about £150 million might fall on holders of securitised notes. Northern Rock’s shareholder funds stood at £2.3 billion at 30 June 2007. Even assuming significant erosion since, the remaining equity in the business should easily absorb any losses barring an Armageddon scenario for the housing market.

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COMMENT:
AUTHOR: Henry Smith
EMAIL:
IP: 145.246.240.14
URL:
DATE: 02/21/2008 12:34:35 PM

Simon, you say that "new lending will be negligible and mortgage rates will be raised to encourage existing borrowers to refinance elsewhere". Are you referring to borrowers on variable rate mortgages and borrowers you are coming to the end of fixed-rate deals? Or are borrowers who still have a few years to go on their fixed-rate mortgage deals likely to see their mortgage rates increased during the period of their fixed-rate deals?

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/21/2008 04:03:37 PM

I am referring to any lending where Northern Rock has discretion to reset the terms. This would not include fixed-rate deals until their expiry but a large volume of such loans mature over the next 18 months.

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COMMENT:
AUTHOR: r swipes
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IP: 78.149.117.211
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DATE: 03/02/2008 09:19:43 PM

that means there’s plenty of dosh to pay decent compo to shareholders who’ve had their asset confiscated by hmg.