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Rock: a reverse run?

• Robert Peston
• 18 Feb 08, 06:20 PM

What is the future of Northern Rock as a state-owned bank?

Well its new chairman, Ron Sandler, has told the existing management of the troubled bank that he likes their rescue plan and intends to nick many of their ideas.

So he's expected to rapidly shrink the Rock's mortgage operation.

That would be achieved by putting up the cost of mortgages - which would encourage borrowers to repay by taking out loans with other banks.

The good news is that the proceeds of these redemptions would reduce the loans to the Rock from taxpayers.

And, on the forecasts of the Rock's existing management, the value of mortgages on the Rock's books could be reduced by up to £50bn over four years.

The Rock would become a much smaller business and would need to employ many fewer than the existing 6000 staff - perhaps half that number.

But if the bank is to have a profitable long term future, so that it can be privatised in a few years time, it needs to attract billions more in retail deposits.

The Rock's managers were aiming to almost double these deposits by 2012.

What does it all add up to?

First that banking rivals may cry foul about what they may claim is unfair Government-subsidised competition for savings.

Just think of it: there could be a reverse run, with savers stampeding to put their money into the new gilt-edged Rock, perhaps the safest bank in the world.

However banking competitors will be delighted that one of the most aggressive discounters of mortgages in recent years could be almost out of the market - which would allow them to put up their mortgage rates.

So increases in the Rock's mortgage rates could be painful for millions of homeowners, not just the Rock's customers.

And it would also be a nightmarish prospect for the Government.

Gordon Brown would not like the notion that his decision to nationalise Northern Rock could lead millions of us to pay more for our homeloans.

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Rock: risk doubled

• Robert Peston
• 18 Feb 08, 08:05 AM

Although Northern Rock has been heading for nationalisation for some time – and I wrote and broadcast last Tuesday that the Treasury viewed public ownership as preferable to either of the rescue plans – the formal announcement was still momentous.

It is the biggest decision made yet by this prime minister (except perhaps for opting not to have an autumn general election).

And it will reverberate for months and years – not least because shareholders are planning to sue for very substantial reparations.

The decision seems to have been made for two reasons.

First, neither the nor a management team were offering as much as the Treasury wanted in fees for tens of billions of pounds of continuing taxpayer support.

I am told there was a £40m gap between what Virgin said it could afford to pay and what the Treasury was demanding, which is big as an absolute number but is peanuts in the context of the Rock’s £110bn balance sheet.

Second, the Treasury was unhappy that Virgin and its co-investors would have made a profit of about £1.2bn – a return of around 75% – before taxpayers received a penny in capital gains for all the financial help we would have been giving.

So although an ultimate profit of about £200m to taxpayers – which is what Virgin thought it could deliver – may seem attractive, the Treasury thought it inadequate give the scale of the risks that would have been shouldered by the Exchequer on behalf of us all.

The prime minister has in the end decided that if taxpayers are going to provide financial support to the Rock for years to come – which we would have done, on the basis of either of the rescue plans on the table – then we deserve all the potential rewards.

The only way to secure those potential rewards is to nationalise.

Put like that, it sounds like common sense.

But here is why nationalisation could turn out to be the boldest decision that the prime minister will ever make.

If he wants all the rewards for all of us, he has to take all the risks.

In nationalising, he has increased the liabilities of taxpayers from £55bn – in direct loans through the Bank of England and guarantees to other Rock lenders – to £110bn, or the entirety of the Rock’s balance sheet.

He has doubled the financial risk for all of us to just over £3,500 per tax payer.

Now the point about the Virgin and management plans is that they would have significantly reduced the risks for taxpayers.

They each offered a cushion of new equity, so that – if the worst came to the worst – they would have suffered in any first round of losses, if the Rock’s business were to run into difficulties.

In Virgin’s case, it would have put in £1bn of new cash equity and the management team was promising £700m.

Given that this cash would have been exposed to potential losses – and would have provided protection to taxpayers against those losses falling back on all of us – they understandably wanted first dibs on any profits that would be made.

So let’s not fall into the trap of assuming that somehow the potential rescuers were rejected because they were being appallingly greedy.

They needed to make a return to justify the substantial investments they were proposing.

If anything, their rejection shows that Gordon Brown is perhaps less comfortable with a market solution than many might have expected.

There is another way of looking at all of this, which is simply that financial markets are so dysfunctional right now that it was impossible to construct a deal at a de facto price that made good commercial sense for taxpayers.

But that was a judgement that the Treasury could have made weeks ago – and it is therefore vulnerable to the charge that by pursuing negotiations with Virgin et al till yesterday it was guilty of a Micawberish refusal to see the harsh economic reality.

Where do we go from here?

Well it looks as though the management team of a nationalised bank, led by Ron Sandler, will more-or-less adopt the reconstruction plan put together by the Rock’s own management team.

That means he will shrink the size of the bank by more than half.

There are likely to be significant job losses.

And Sandler will probably jack up mortgage rates, to encourage Rock borrowers to take their custom elsewhere.

There would be political dangers for the government in being seen to be responsible for the financial pain of homeowners and job losses in the North East.

But it is difficult to see how it can escape them.

Then there is the £110bn question.

Can taxpayers avoid a loss on all those liabilities?

Well that depends on whether the current gentle downturn in the economy turns into something worse.

If unemployment were to rise significantly, if large numbers of homeowners started to have difficulty repaying mortgages, then the bank which lent most aggressively during the last phase of the bull market in housing would probably be most at risk to losses in the downturn.

That bank, lest we forget, is Northern Rock.

And if it all goes horribly wrong, it is now taxpayers who will pick up the whole bill.

UPDATE 08:48 The Rock is now, arguably, the safest bank in the UK. Will savers now flock to put money back in, to take advantage of its wholly risk-free, fairly high savings rates?

At a time of almost unprecedented unease about the health of the banking system, the Rock has a massive competitive advantage as part of the public sector.

Its rivals will be very unhappy about the competitive threat. They are desperate for funds – and won’t want to see deposits gravitating to what is now an offshoot of HM Treasury.

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