What’s this? Northern Rock has fallen below its minimum regulatory requirements?
Northern Rock’s capital base has now reduced to a level below its minimum regulatory capital requirement. Northern Rock proposes to address this situation through a legal and capital restructuring of the Company and HM Treasury’s commitment to provide an adequate level of capital for the Company to meet its regulatory capital requirements, once the proposed restructuring is completed and subject to appropriate State Aid clearance being obtained from the European Commission.
Indeed.
The proposed restructuring is essentially an exercise in capital arbitrage, with the aim of lowering the financial burden borne by the UK government, which nationalised Northern Rock back in early 2008.
It’s basically a good bank/bad bank split, with Bank Co. holding onto Northern Rock’s retail and wholesale deposits as well as a few of their unencumbered mortgage assets and Asset Co. keeping the rest of the existing residential mortgage book, including those assets currently tied up in securitisation and covered bond operations. The former being the great Granite securitisation.
Bank Co. will be regulated by the FSA, and be required to keep minimum capital requirements, while Asset Co. will not be under the regulator’s rules and will therefore get to have lower capital targets. Very clever HM Treasury.
In any case, the split could have a rather interesting effect Northern Rock’s securities, in particular the bank’s €10bn covered bond programme.
JPM have estimated the split will look like this in terms of assets:
Now while Asset Co. may end up having £78bn or so in assets, about £42bn of that is already legal segregated as a part of securitisation and covered bond operations, according to JPM. Covered bonds, lest we forget, are bonds backed by on-balance sheet collateral — in Northern Rock’s case mortgages.
Here’s a snippet from Fitch ratings, back in 2005, on how the covered bond programme is structured:
The Covered Bonds issued from Northern Rock’s covered bond programme are guaranteed by Northern Rock Covered Bond LLP (“the Covered Bond Guarantor” or “the LLP”), a partnership entity established for the purposes of the programme. As mentioned above, the Covered Bond Guarantor collateralises its guarantee through the purchase of residential mortgage loans originated in England, Wales and Scotland by Northern Rock. This guarantee will only be called upon in the event of the Issuer defaulting on the Covered Bonds. The Covered Bond Guarantor is incorporated in England and Wales as a limited liability partnership (“LLP”), with Northern Rock as one of its members.
On an ongoing basis, Northern Rock agrees to sell new mortgage loans to the Covered Bond Guarantor on a “best efforts” basis in order that the Asset Coverage Test is met on each monthly calculation date.
That LLP is essentially an SPV, which uses the intercompany loan given to it by Northern Rock to purchase mortgage loans.
As noted above, the LLP is required to ensure that the adjusted value of the mortgage loans will be at least equal to the amount outstanding of the covered bonds — the so-called Asset Coverage Test. Here’s a bit more detail from an old Barclays note:
The Asset Coverage Test is designed to ensure that at each calculation date, the adjusted aggregate mortgage loan amount in the cover pool is at least equal to the GBP equivalent of covered bonds in circulation. The test also requires that Northern Rock sells enough mortgages to the LLP or provides it with a cash capital contribution if the Asset Coverage Test is breached.
Understandably, there are now some concerns about whether the new Asset Co. of Northern Rock will have enough collateral to replace non-performing loans and meet the conditions of the Asset Coverage Test; something particularly salient given Northern Rock’s recent mortgage difficulties.
However, unlike Granite, which underwent a Non-Asset Trigger Event back in November 2008, after failing to maintain its minimum seller share level, it looks like Northern Rock’s covered bond programme will get some sort of government guarantee.
From The Cover:
The UK government’s plan to split Northern Rock in two will result in covered bonds being assigned to the “bad bank” and being guaranteed to maturity, a European Commission document suggests. . . . Some sections of the document as published by the EC are omitted for “professional secrecy”, so it is not completely clear what the UK has proposed. However, in a section where guarantee arrangements are discussed, the document says: “All guarantee arrangements are subject to a minimum period of three months between the government giving notice and guarantees being lifted. However, some products 9such as fixed term bonds) are guaranteed for their term, so in these instances guarantees will roll off as the products expire.
he document then says: “The wholesale guarantee arrangements for AssetCo are likely to remain in place until exit or liquidation.”
Related links:
Stony broke – fresh rumblings from Northern Rock – FT Alphaville
Covered bonds in the spotlight – Practical Law Company