Northern Rock cries for help as funding markets ostracise it

The BBC reported late yesterday (Thursday) that the central bank, in cooperation with the Financial Services Authority and the UK Treasury, had agreed to act as lender of last resort to Northern Rock.

The bank has suffered a severe liquidity squeeze as its main sources of funding in the capital markets have dried up.

The amount of the facility draw is unknown. Neither Northern Rock nor the Bank of England could be reached for comment.

But the event brings much closer the threat that banks’ constrained access to funds could precipitate a disaster. Unlike IKB Deutsche Industriebank and SachsenLB, which both had to be rescued in August, Northern Rock is not believed to be harbouring any exposure to US subprime mortgages — or indeed any substantial credit losses.

Northern Rock has had to call on the Bank of England because private sector banks and other lenders will no longer extend it enough credit.

The markets have apparently lost faith in Northern Rock simply because it is regarded as an aggressive mortgage lender — something out of favour at present, even though the UK mortgage market is healthy — and most of all, because it relies heavily on the wholesale markets for funding.

The astonishing frailty this summer of capital markets that once seemed all-powerful may force investors and rating agencies to rethink how much they can rely on capital markets "being there" to finance banks and other financial institutions, even industrial companies.

Crunch to come today

Today (Friday) will be a critical day for Northern Rock. Its unsecured debt, covered bonds, credit default swaps and equity are likely to be hammered in the secondary markets, and its financial position will be scrutinised minutely.

The precise trigger for the crisis is not known, but Dealogic databases suggest that Northern Rock did not face any imminent large redemptions in the ECP, MTN or bond markets. It is more likely that it was denied credit at an acceptable price by other banks.

Northern Rock usually issues a large securitisation of its residential mortgages at the beginning of September; this year, it had to abandon the deal because of market conditions.

Two market participants highlighted the troubles in the asset backed commercial paper market as having undermined Northern Rock. The bank does not have its own ABCP programmes but may sell mortgages to other banks’ conduits as a form of warehouse finance.

Under the memorandum of understanding governing cooperation between regulators and the government, the FSA and the Bank of England must alert the Treasury under certain circumstances including "where a serious problem arises, which could cause wider financial or economic disruption" and "where there is, or could be, a need for a support operation".

Use of the emergency facility "is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system, to avoid a serious disturbance in the UK economy".

While Northern Rock’s solvency is not believed to be threatened, the action will deal a severe blow to its reputation. It would probably only have been taken to prevent a complete deterioration of confidence in the UK banking sector, already hit by extensive liquidity draws to support structured vehicles.

Stretched balance sheet

Northern Rock is more susceptible than most banks to the current market freeze because it has a small deposit base — retail funds made up 26.7% of outstanding liabilities in the first half of 2007, less than half the UK average — a strong focus on residential mortgage lending and an aggressive capital structure. The bank had an 18.9% share of net mortgage lending in the UK over the same period.

"The scenario that no one had counted on, where ABCP would fail, has happened," said one senior financial institutions debt capital markets banker. "As an institution, Northern Rock is wholesale-funded at 80% and simply could not access liquidity from the markets where it normally gets it. Also, this is a very lean organisation with not much capital in the coffers and the market situation has hit it hard."

According to Northern Rock’s interim results, non-retail funding comprising short and medium term debt made up 25.5% of its funding base at June 30, securitisation 43.6% and covered bonds 7.8%.

The most prolific mortgage securitiser in Europe, Northern Rock tested investors’ interest in a new securitisation from its Granite master trust a few weeks ago but did not attract enough interest to execute the deal with sufficient volume to make it worthwhile.

Furthermore, Northern Rock’s outstanding RMBS have been among the hardest hit in the secondary market because of persistent shorting through credit default swaps, dealers trying to clear their books of paper and expectations of a new issue.

Its covered bonds have also widened further than that of other UK banks, performing particularly badly this week (see story on facing page).

Repo puzzle

It is unclear why Northern Rock did not issue a securitisation to use as collateral in repo transactions to raise short term liquidity.

While the Bank of England does not accept RMBS or other asset backed securities as repo collateral, the ECB does accept compliant euro-denominated issues and previous Granite issues are included in the list of eligible assets.

Furthermore, there is still an active interbank repo market in such securities, according to bankers.

But most of all, the news is a clear indicator of how the crisis initiated by credit problems in securities backed by subprime mortgages in the US has become one of liquidity, with banks unwilling or unable to lend to each other even if the assets on their balance sheets are sound.

While Northern Rock does operate at the riskier end of the spectrum for mainstream lenders, with a high proportion of self-certified loans, arrears on its mortgages remain low with just 0.47% of its mortgages three months or more delinquent at the end of June, below the Standard & Poor’s prime RMBS index.

"What is interesting is that from a Basle II perspective, Northern Rock is a fantastic buy," said the same banker. "They have very low cost-income ratios, originate quality assets and this shouldn’t have happened. However, by funding so much over one to three month markets, they have come unstuck and a big bulk of rolling paper is due in the coming weeks."

According to CPWare, Northern Rock has $212m of ECP maturing next week, $225m the week after and $667m more in October. Figures for US CP were not available. In addition there are two medium term notes totalling $1.9bn maturing in October.

One senior securitisation banker said that Northern Rock had tried to obtain a warehouse facility backed by its mortgages to raise short term funds but had been unable to do so. The official also said Royal Bank of Scotland had agreed to buy Eu1bn of triple-A RMBS from the next Granite issue. Neither of these claims could be verified. RBS declined to comment.

The banker praised the use of the Bank of England facility as a short term measure while the primary ABS market was shut, pointing out that it was shut even to the best quality issuers.

Last week the highly regarded VW Bank briefly marketed a car loan securitisation before pulling the deal within hours.

Chris Dammers