Northern Rock: Narrative
Northern Rock – History
- Northern Rock began in the nineteenth century as a mutually owned “building society”, with a business focused on serving its local community.
- The bank went public in 1997 and grew at an annual rate over 20 percent for the next ten years, with total assets of 113.5 billion pounds, the fifth largest U.K. bank by mortgage assets, as of June 2007.
- Northern Rock focused on prime lending, had minimal subprime exposure, and the U.K. housing market remained strong in the summer of 2007.
- But rapid growth starting in 1997 outstripped the traditional deposit base, and the bank had to rely on non-traditional funding sources.
Repo – 2007
- Over the summer of 2007, some of these nontraditional funding sources began to dry up, and efforts to organize a private rescue for the bank failed.
- On 9/13/07, the BBC broke the news that Northern Rock had sought assistance from the Bank of England; the BoE granted that assistance the next morning. The run on retail-branch deposits began that day.
- At the time of the run, full deposit insurance in the U.K. was capped at 2000 pounds, and then 90 percent up to 35,000 pounds.
- Despite the public nature of the retail-branch run, the real story was a wholesale run that had intensified in the previous month.
Northern Rock – The Puzzle
“The real question raised by the Northern Rock episode is not so much why retail depositors are so prone to loss of confidence that lead to bank runs, but instead …
why sophisticated lenders who operate in the capital markets chose suddenly to deny lending to a bank that had an apparently solid asset book and virtually no subprime lending.”
Northern Rock and the Global Financial Crisis
The “Monolines” – Background
- Since they began in the 1970s, bond insurers main business was to provide credit enhancement to municipal bond offerings.
- This insurance was provided by specialized companies that do not sell other types of insurance products – hence the name “monolines”.
- In the roaring 2000s, they expanded into insurance provision for structured products (securitizations and CDOs).
- January 2008, MBIA and Ambac (the two largest insurers), had a combined $265 billion in structured-product guarantees.
- Starting in mid-2007, the markets became worried about these insurers.
Source: FCIC, p. 276
Auction Rate Securities – Background
- The traditional way to sell securities is with a primary offering, followed by the management of a secondary market. For some types of securities, the secondary markets are so illiquid that investors are scared away.
- Auction rate securities (ARS) are a solution to this illiquidity, with a broker-dealer holding periodic auctions of long-term bonds to reset the interest rates based on demand.
- Historically, broker-dealers reputational concerns meant that they provided a backstop to the market, holding paper to manage shortterm liquidity disruptions.
- ARS are used for a very quiet type of securities: mostly studentloan pools and municipals.
- The municipal securities were given credit enhancement by the monolines … uh-oh.
- In mid-2007, Bear Stearns was the fifth-largest investment bank in the United States, with assets of about $400 billion.
- The firm was a significant player in all parts of the subprime space, from loan origination to trading.
- The first problem occurred in June 2007, with a suspension of redemptions in two Bear-managed hedge funds.
- For reputational reasons, Bear bailed out these funds after liquidation on 7/31 by paying off their lenders and taking the collateral onto its own balance sheet.
- This action, and the losses from other asset holdings, were not nearly enough to drive Bear Stearns into insolvency. So what happened?
What happened? A remarkable combination of liquidity pressures that took virtually everyone by surprise.
- Prime brokerage withdrawals
- “Novations” of derivatives
- Collateral calls
- Maturity shortening on secured “repo” loans
- And, finally, a run on repo
- The Federal Reserve supported a JP Morgan buyout of Bear Stearns, initially set at $2 per share, later raised to $10.
- After Bear Stearns policymakers introduced several new tools to support liquidity in interbank markets.
- The markets did not learn their lesson. The failure of Lehman Brothers six months later followed a similar script.
- Some argue that Fed actions during the Bear Stearns crisis created a false sense of complacency and belief that there would always be support for other “too-big-to-fail” institutions – a belief that proved false and damaging before Lehman.
- An alternative explanation is that these wholesale banking operations were inherently fragile – in ways that were simply not understood at the time – and our regulatory system was not equipped to handle their rapid failure.
- Institutions with subprime exposures began to fail in early to mid 2007.
- These failures were not expected to be a problem for broader economy, but led to stresses in wholesale funding markets, notably the ABCP market.
- These tensions would contribute to failures of seemingly unrelated or sufficiently insulted firms and markets: Northern Rock, auction rate securities and Bear Stearns.
- The vulnerabilities were not fixed, and there would be worse problems to come.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
Financiers who bought ‘distressed’ Greek debt insist on making vast profits from the crisis
A group of hedge funds is threatening to block a last-ditch attempt to save Greece from defaulting on its huge debt pile, unless they are guaranteed a significant payout.
There will be a final attempt today – when a group representing Greece’s private sector bondholders meets senior ministers in Athens – to negotiate a writedown of the value of the country’s debt ahead of a crucial bond repayment deadline next month.
Sources familiar with the talks, which collapsed at the end of last week, have said that a number of hedge funds are holding up the restructuring deal to ensure that they make a fat profit, after snapping up Greek bonds at distressed prices.
Greece’s official backers – European governments and the International Monetary Fund – have said they will not deliver the next tranche of bailout funds that Athens needs to redeem €14.4bn (£12bn) in maturing bonds on 20 March unless a deal to cut Greece’s €355bn debt pile by €100bn is concluded by the end of the month. Without those bailout funds, Athens will be forced into a disorderly default, which could plunge the eurozone into further financial chaos and possibly prompt Greece’s exit from the single currency.
“It’s very serious,” said market analyst Nicholas Spiro of Spiro Sovereign Strategy. “The notion that a disorderly default by Greece can be ring-fenced is wearing thin and the markets don’t believe it.” Yet fears have grown in recent weeks that the hedge funds that are blocking the deal – which have been identified as including Vega Asset Management, Och Ziff, York Capital, GreyLock Asset Management and Marathon Asset Management – do not consider the prospect of a disorderly default by Athens as a financial incentive to allow a voluntary writedown deal to proceed.
This is because these funds are believed to have purchased insurance policies on their holdings of Greek bonds, known as Credit Default Swaps (CDS). If Athens fails to pay its maturing debts in March, that would trigger large CDS payouts to these funds from the large financial firms that sold them the insurance. Charles Dallara, the managing director of the Institute of International Finance (IIF), and Jean Lemierre of the French bank BNP Paribas, have been negotiating on behalf of the private sector bondholders. Last night Mr Dallara flew from Washington to Athens and talks will recommence this afternoon.
Negotiations broke down because agreement could not be reached about the size of the “coupon”, or regular payment, on the new discounted Greek bonds that will be given to investors in exchange for their old investments.
The International Monetary Fund, which has contributed to the Greek bailout, is reported to have been pushing for an annual coupon of only 2 per cent, which could reduce the long-term value of the new bonds by up to 75 per cent. Germany, the biggest single contributor to the eurozone’s bailout fund, has also been pushing for a low coupon.
A spokesman for the IIF indicated that a small number of hedge funds would not be allowed to hold the talks hostage and that if a sufficient number of bondholders agreed on the size of the coupon, the deal would be done.
“There is a need to get a critical mass of bondholders to participate. That is always the aim of negotiators. There will always be a few holdouts,” he said.
However, a hedge fund source denied that the behaviour of small investment funds was frustrating a voluntary deal – and possibly even forcing a default – arguing that the voluntary basis of the restructuring deal being pushed by the IIF and European leaders was “crony banking”. “Who will lose out if the insurance is paid out?” he said.
“The two biggest issuers are Goldman Sachs and AIG. They are effectively being given a bailout by not allowing Greek debt to default. Seven Goldman Sachs ex-employees are in European Union governments. This is crony banking at its worst.”
The pressure on eurozone investors increased when the credit rating agency Fitch said it would consider Greece to have defaulted even if it concluded a voluntary writedown deal.
“It clearly is a default, however they try to spin it” said Edward Parker, managing director of Fitch’s Sovereign and Supranational Group in Europe.
No deal: The hedge funds blocking Greek bailout
York Capital Management
The group, which is housed above an Apple store in New York, has $14bn (£9bn) in assets. It was founded in 1991 and is part-owned by the Swiss banking group Credit Suisse. Founder and senior managing director Jamie Dinan has a reported net worth of about $1.2bn.
Marathon Asset Management
Another New York fund, Marathon describes its “core competency” as “distressed and situational investing”. The 14-year-old, $10bn firm, founded by CEO Bruce Richards, is a member of the private sector creditor-investor committee, which is involved in protracted negotiations with the Greek government.
One of the largest hedge funds in the world, it manages about $28.4bn for its clients. Listed on the New York Stock Exchange in 2007, the fund was founded in 1994 by Daniel Och with support from the Ziff family. Mr Och spent 11 years at Goldman Sachs before forming the fund, a joint owner of the Peacocks retail chain.
GreyLock Asset Management
GreyLock claims to have dealt with $75bn of sovereign and corporate debt since it started operations in 1998. It is run by Hans Humes, who represented around $40bn of interests while Argentina’s balance books were being restructured.
Vega Asset Management
Formerly one of Europe’s largest hedge funds, Vega is not as powerful as it was but still unsettled markets when it threatened to sue Greece if restructuring of its debt made losses too big for its liking. Founded in 1996 by a former trader at Banco Santander, it resigned from the steering committee and demanded that at least half of Greece’s debts be repaid.
(Reuters) – Hedge funds are taking on the powerful International Monetary Fund over its plan to slashGreece‘s towering debt burden as time runs out on the talks that could sway the future of Europe’s single currency.
The funds have built up such a powerful positions in Greek bonds that they could derail Europe’s tactic of getting banks and other bondholders to share the burden of reducing the country’s debt on a voluntary basis.
Bondholders need to give up some 100 billion euros (83 billion pounds) of their investment in the planned bond swap, drawn up in October, but many hedge funds plan to stay out of it.
They either prefer letting the country go under, which would trigger the credit insurance they have bought, or hope to get paid out in full if enough others sign up. That puts them in direct conflict with the IMF, which wants to force Greece’s cost of financing down to an affordable level.
“The play is purely ‘they’ll be forced to pay me’. Greece will want to avoid a wider default� so if it managed to restructure 80 percent of the deal and pay the rest that’s still better,” said Gabriel Sterne at securities firm Exotix.
EU Economic and Monetary Affairs Commissioner Olli Rehn said on Tuesday that negotiators were “about to finalise shortly” . But time is running out.
Without the money, the country is likely to default around March 20, when a 14.5 billion euro bond falls due. A deal needs to come well before that, because the paperwork alone takes at least six weeks.
But the hedge funds are resisting, unlike European banks holding Greek bonds, who have been pressured to agree by politicians.
There are other barriers too.
Banks represented by the Institute of International Finance IIF.L agreed last year to write off the notional value of their Greek bond holdings by 50 percent, a deal designed to reduce Greece’s debt ratio to 120 percent of its Gross Domestic Product by 2020.
But they have been unable to agree on the fine print of the refinancing – the coupon, maturity and the credit guarantees. These will determine the bonds’ Net Present Value NPV.L, and thereby the actual hit the banks need to take.
There are 206 billion euros of Greek government bonds in private sector hands — banks, institutional investors, and hedge funds — and it is likely that hedge funds have been building up their positions in the past months.
They have been snapping up chunks of Greece’s next big maturing bond, the March 20, for around 40 cents on the euro. Yields on the bond began to rise sharply in September and it was priced at 41-45.5 cents in the euro on Tuesday.
The bet is that other creditors will sign up to a voluntary deal, and that Greece will pay out in full the hedge funds who do not to avoid a default and trigger pay-out of Credit Default Swaps, a form of credit protection.
“Time is on your side, since investors, until now, have received full repayment on Greek debt obligations,” said Kristian Flyvholm at asset manager Jyske Invest.
Sterne, whose firm Exotix specialises in illiquid bond investing and counts hedge funds among its clients, said the bet had already worked for some funds. Greece paid out smaller issues maturing in December and January.
But it is a dangerous strategy.
Europe is increasingly likely to force investors to take a cut on their Greek bond holdings if they do not voluntarily sign up to the deal, Reuters reported in November.
Also, Greece could change its laws, which for the largest part do not contain the so-called Collective Action Clauses CAC.L that force dissenting minorities into line when new conditions are imposed on outstanding bonds.
It is unclear how large hedge fund holdings of Greek debt are. About 20 to 25 percent of Greece’s creditors were unidentified, and half of these could be hedge funds, one source close to the creditors told Reuters.
Whatever the scale of the hedge fund threat, the proportion of creditors seen likely to sign up for their haircut has slipped. The hopes are now 60 percent can be convinced by the end of the month, the same source said, far less than the 90 percent take-up the IIF was targeting in June.
At that low a level, it is unclear whether the troika of international lenders will consider the uptake big enough to warrant a pay-out of the second bail-out package.
IIF Managing Director Charles Dallara is due in Athens later this week for troika negotiations, and technical staff from the IMF are expected in the Greek capital from January 16.
The IMF itself seemed to throw doubt on the debt swap in an internal memo cited by German magazine Der Spiegel on Saturday.
According to the report, the IMF believes Greece will still be sinking under the burden of its debts even after a deal is struck, and that further measures may need to be taken if the country is to avoid default. Markets fear this could lead to reopening the October agreement.
In a leaked paper in October, the IMF already acknowledged that it’s the assumptions may need to be reassessed. That would mean lower interest rate payments by Greece, and an even more bitter hit for the banks.
The NPV loss for creditors could be near 65-70 percent and the coupon around 4.5 percent, bankers have indicated. Reuters reported in November Greece wanted a 75 percent NPV cut, a far higher number than the low 60s the banks had in mind.