The Future of Northern Rock: The Maths Adds Up
A tug of war has begun at the top of the government over the future of Northern Rock as senior figures argue that the Treasury’s planned sell-off should be stopped so that the ailing bank can instead be turned into a building society owned by its customers.
The move would mean forgoing a potential £11bn windfall for taxpayers but some cabinet ministers and No 10 officials believe this option is preferable to selling the bank to a rival or refloating on the stock market since it would leave the bank less prone to instability and financial risk.
However, there are concerns within the Treasury, which needs to reduce public debt and claw back some of the £25bn of taxpayer money which was used to bail out the bank in 2008.
The final decision will be taken by ministers but they want to win the support of UKFI, the company set up to run the nationalised banks after last year’s crash. Senior government sources believe there is a convincing case that taxpayers would benefit in the long term if a remutualised Northern Rock were able to help less well-off customers get low-interest loans.
I’m quite fond of the idea of Northern Rock returning to its roots and becoming a mutual.
Mutuals are not a panacea. The collapse of Dunfermline Building Society shows that. But they do, when well run, tend to perform the core retail task of offering savings accounts and making mortgages well as they don’t need to generate an excess return for shareholders – Nationwide is a great example. In the case of Northern Rock the numbers stack up well.
It’s difficult to say at this stage exactly what a re-mutualised Northern Rock would look like but the first half 2009 results provide some clues. The current plan is to split into a ‘good bank’ and ‘bad bank’ – similar to what happened to Bradford & Bingley (with the ‘good’ bit then being sold to Santander).
Northern Rock currently has (as of June) £88.7bn of assets, including £62bn of mortgages. Buy to let loans make of £5.6bn of the total. Although bad debt charges were £600mn in the first half, £300mn of that came from unsecured personal loans and another £60mn from BTL loans.
Even so, some of the mortgage book is not great (remember their 130% loan-to-value ‘Together’ loan?). The overall LTV for the mortgage book is 74%. Whilst LTVs over 100% represented 39% of the total book.
Loans with an LTV above 100% are obviously more risky (if the borrower defaults the collateral (house) won’t cover the losses), but most people will not default. As of June, 3.92% of the mortgage book was in arrears.
It seems fair (and very conservative indeed) to assume that 80% of the loan book is fine. So let’s imagine that the ‘good bank’ that would be remutalised can take £40bn of the mortgage book (only 65% of the book and the highest quality).
In simplified terms it then needs to ‘fund’ that £40bn of assets (obviously it will have some other assets too – cash, branches, etc). My ideal solution would be to transfer all deposits (£20bn) and covered bonds (£10bn) to the new mutual. The remaining gap of £10bn would be plugged by transferring across £10bn of the £30bn of securitised bonds. This would not involve issuing any new securitised debt, just shifting some outstanding bonds.
This would leave NR with a loan to deposits ratio of 200%. Which is high, but could be brought down over time assuming it attracts savers. The first priority of the new NR would be to reduce dependence on securitised debt.
Crucially it would have to fund all new lending through new deposits and would have to have no reliance on overnight and other short term funding. This is all achieved in the structure outlined above and so avoids the problems that led to the downfall.
How much value could this new NR offer customers? Actually quite a lot.
The running costs of Northern Rock (excluding exception items) were £107mn in the first half of 2009. Annualising that we get a running cost of about £250mn (with some leg room). And remember building societies don’t have to generate a ‘profit’.
So if we have a bank with £40bn of mortgages needing to generate net interest income (the difference between income received on assets (loans) and paid on liabilities (deposits) of £250mn, what is the required spread (the difference between loan rates and deposit rates)? The answer is a very low 0.625%. The net interest margin for the UK banking as a whole for retail customers is currently 2.35%. Let’s say that Northern rock should aim for a spread of 0.80% (generating a surplus £70mn a year).
So a mutualised Northern Rock could either charge 1.55% less on mortgages than other banks, offer 1.55% more savings or some combination of the two.
I’d be inclined initially to focus on offering more on savings to raise deposits.
A net interest margin 1.55% below the UK average, on a £40bn loan book, would benefit Northern Rock customers to the tune of £620mn annually either through lower repayments or higher savings income.
Selling Northern Rock could raise £11bn. If that was used to reduce the public debt it would reduce the annual interest bill by only £396mn (Government debt yielding 3.6%).
Remutualising represents an annual saving of £224mn for the UK economy.