Treasury underwrites ailing bank's bailout

Treasury underwrites ailing bank's bailout

The Treasury yesterday revealed itself as the ultimate guarantor behind Northern Rock's rapidly spiralling emergency loan facility with the Bank of England as it gave the troubled high-street bank breathing space until February to sort itself out.

The government is understood to have moved in after it became clear that urgent requests from the Newcastle lender for an easing in its penalty lending terms could not be met under the Bank's strict criteria as lender of last resort.

Economists estimate Northern Rock borrowings from the Bank have increased by £2.3bn in seven days and total about £12.9bn, since it first sought lender of last resort funds four weeks ago.

It emerged yesterday that, after urgent requests from the ailing lender for a loosening in lending terms, Treasury officials earlier this week secured a deal that enabled the Bank to relax its collateral requirements - a move that governor Mervyn King had previously opposed.

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A spokesman for the Treasury yesterday insisted the deal was "absolutely not a politicisation of the Bank in any way, shape or form".

Earlier in the day, chancellor Alistair Darling told the House of Commons that the Bank's lender of last resort facility extended to Northern Rock had been "replaced". Terms on the Bank's replacement facility allowed Northern Rock to put up "all of its assets" as collateral, including its £7.8bn of unsecured loans. Until this relaxation, the Bank's original lender of last resort facility to Northern Rock meant the need to minimise risk to the taxpayer had required Threadneedle Street to accept only high-quality collateral at a discount.

These tough terms, however, restricted Northern Rock's efforts to secure loans in the wholesale money market. Government sources admitted that the new arrangements involved a higher degree of risk, but the Treasury was forced to step in once it became clear that the calmer mood in the financial markets had seen no end to Northern Rock's severe liquidity crisis.

In a stock market statement, the Treasury yesterday revealed: "In view of the scale and nature of the new facilities, the Treasury has agreed to indemnify the Bank of England should the Bank of England face a deficit having previously made all reasonable endeavours to recover its claims on the company."

In recognition of the Treasury's new role as ultimate guarantor, the penalty premium on the interest rate for Northern Rock's emergency funding will go back to coffers at the Treasury rather than the Bank. The penalty premium on Northern Rock's emergency Bank borrowings has not been disclosed but is thought to be about 1%.

Payment of the penalty premium will not be demanded by the Treasury until the end of the loan term in February next year. The debt will be classed alongside subordinated debt in Northern Rock's capital structure. Subordinated debtholders, who have hired the investment bank Houlihan Lokey Howard & Zukin as advisers, have expressed concern that their investments in the ailing bank may be compromised by a rushed takeover or restructuring. The cost of insuring subordinated debt has been soaring on the credit default swaps market. Even the cost of insuring Northern Rock's senior debt, covered by a Treasury guarantee, has been climbing fast.

Simon Ward, economist at New Star, said the estimate of Bank of England support to Northern Rock had slowed to £2.3bn this week from £2.9bn in the week to October 3 and £4.9bn in the week before. "Continuing erosion of Northern Rock's funding base explains the government's decision this week to extend its guarantee to new retail deposits," he said.

Analysts had pencilled in refinancing obligations of about £14bn in the second half, with £30bn of funding obligations over the following 12 months. Without a step-up in activity in the wholesale banking market or a rush of new depositors, these estimates are looking increasingly conservative.

Backstory The Financial Services Authority, the City regulator, and the Bank of England are to issue a joint discussion paper on liquidity issues facing City institutions in increasingly complex markets. In a statement to the House of Commons on the Northern Rock crisis, chancellor Alistair Darling said: "It is important regulators focus on liquidity as well as solvency." Earlier in the week the FSA admitted its discussions with Northern Rock over liquidity "stress testing" had not anticipated the abrupt freezing of the short-term credit market that transpired.

Separately, Mr Darling published a consultation paper on bank depositor protection. He recently raised the sum guaranteed to £35,000. "This is just an initial step towards a more comprehensive change," he told MPs. This is likely to require legislation, with a bill expected early next year.

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