Jeremy Warner's Outlook: Abuse or stabilisation... call it what you will

What price Northern Rock?
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The Independent Online

Bankers don't tend to act out of altruism, so when three of them get together to launch a $75bn lifeboat to help bail out "structured investment vehicles" and "conduits", it's more than usually worth delving into why.

If this were an initiative organised by the Federal Reserve or the US Treasury, then every man and his dog would have been dragooned into the effort. As with the Long Term Capital Management rescue back in 1998, those who refused would have been punished with exclusion from the "Wall Street Club" for years to come.

Yet, though the Master Liquidity Enhancement Conduit (MLEC) – or the Frankenstein Fund, as it has already been christened by some investment bankers – carries the support of the US Treasury, it is in fact the initiative of just three players – Citigroup, Bank of America and JP Morgan.

The purpose of the fund is to provide a safety net to catch distress sales of mortgage-backed securities and other forms of dodgy debt as they come on to the market. By so doing, the bankers hope to put a floor under the price of these instruments and thereby help stabilise the market. What's proposed is nothing short of a massive price support operation, possibly the largest ever attempted. It can reasonably be assumed that the banks that have backed the idea are the ones most exposed to the problem.

Citigroup invented the "structured investment vehicle" in the 1980s and sponsors more of them than anyone else. In all likelihood, it also operates more conduits – off-balance-sheet financing vehicles that do much the same thing as SIVs, but for the direct benefit of the sponsoring bank.

The credit crunch has made both structures increasingly difficult to finance in the commercial paper market. As liabilities fall due, many have little option but to sell their assets, creating the potential for a downward spiral in prices.

The alternative is that the sponsoring bank takes the assets direct on to its balance sheet. Citigroup has already written off $1.3bn on mortgage-backed securities and collateralised debt obligations, but these were the ones it had directly on the balance sheet. Who knows how big the potential liability off balance sheet might be?

No wonder Chuck Prince is referred to as the banker formerly known as chief executive of Citigroup. The only thing that sustains him in the job is the belief that to sack the boss now might make things even worse.

Banking is all about confidence, and the hope for Mr Prince is that simply announcing the MLEC may be enough. A bit like a nuclear weapon, the idea is that its very existence should mean it never has to be used. This is how all banking lifeboats are supposed to work. The point of providing the rescue finance is not in the expectation of losing it, but rather for that of bolstering confidence.

On another level, it seems outrageous that Citigroup should be allowed to protect its bottom line in this way. Didn't Ernest Saunders go to jail for something similar? By propping up the price, bankers ensure that the damage isn't quite so bad when the assets are marked-to-market on being reabsorbed on to the balance sheet. But please don't call it market abuse.

What price Northern Rock?

One question that won't be uppermost in MPs' minds when they come to grill the chairman and chief executive of Northern Rock today is whether the stricken mortgage bank might still be worth anything. Blame and retribution is what the body politic is chiefly interested in. Yet, for all the barking of dogs, the caravan moves on, and for the City, the only object of interest is whether there is any value left in the carcass.

If Northern Rock is really worth as little as some of the potential bidders claim, how come there are at least three of them interested in acquiring it? The question only needs to be posed for it to be realised that the assertion of worthlessness is largely self-interested nonsense. But if not completely valueless, then how much? The continued two-way pull between long and short positions among hedge funds in the stock powerfully illustrates the difficulty of coming up with meaningful answers.

Oriel Securities' Mike Trippett seems to find himself virtually alone in thinking there any upside in the shares at yesterday's close of 215p a share. Most others are distinctly bearish. Yesterday's guarded statement from Northern Rock, referring as it did to the "preliminary" nature of any proposals and to uncertainty over their outcome, has hardly helped to calm nerves, though personally I wouldn't read too much into what looks like a standard form of words for announcements like this.

Plainly, Northern Rock would indeed be worth nothing without the Treasury guarantee and the Bank of England's lender of last resort facility. In circumstances where these were removed, Northern Rock would be insolvent and therefore forced to call in the administrators. But then, so would quite a number of other banks in Europe and America who have similarly availed themselves of large quantities of central bank support.

As has repeatedly been stated by those involved in the debacle, the problem is not solvency but lack of confidence and liquidity. Any number of banks and businesses would be bust if their traditional lenders suddenly decided that they no longer wanted to lend to them. Banks are like perpetual motion machines; as long as everyone believes in the illusion, they work fine. When the illusion is shattered, they fall apart. But that doesn't mean they are worthless.

One of the potential Northern Rock rescuers is Cerberus Capital Management, the American private equity firm. Cerberus knows as much as there is to know about this phenomenon, having been involved in the rescue of both Long Term Credit Bank in Japan and BAWAG in Austria. In both cases, the model seemed broken beyond repair.

Yet just a few years later, when everyone had forgotten about the scandals that sank them, they were suddenly worth a fortune again. What at the time looked like a high-risk gamble by Cerberus turned out to be no risk at all. That's the trick everyone so desperately trying to talk the price of Northern Rock down is hoping to repeat with the troubled British mortgage bank.

Might the British Government be forced to relinquish its support and allow Northern Rock to go to the wall? Technically, support of this type could after six months fall foul of EU rules governing state aid. Yet the Rock is paying on commercial terms for this support, and in any case it seems unlikely that Europe would push the point given the billions the European Central Bank has doled out to ease distressed bankers.

No need, then, for Northern Rock to be hurried into a deal at rock-bottom prices. The great bulk of the loan book remains high quality, so even assuming some sort of a haircut on assets, the stated book value of £4 a share should not be significantly impaired.

Virgin must be right in insisting that the Northern Rock brand is dead. What's more, the business almost certainly needs new equity to be weaned off the drip-feed of Treasury and Bank of England support. Add to this more difficult conditions in the British mortgage market, and it seems unlikely that the bank's share price can any time soon again hope to trade on the three times book value it enjoyed little more than six months ago.

That price was predicated on breakneck rates of growth which, as we now know, were achieved only at a price. Financial regulators would not allow Northern Rock the leeway to grow at that pace again, even if managers felt so inclined. All this suggests a price-to-book value going forward of possibly no more than two times. Yet even assuming a £1bn equity injection at a big discount, that still leaves the shares looking significantly undervalued at their current level.

Still, this is high-risk stuff. Best leave it to the hedge funds.

j.warner@independent.co.uk

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