I have been endeavouring to write up my research on the infamous Bradford & Bingley subordinated bonds for some time now - hence the lack of articles on my blog of late. However, researching the bonds has been a bit like trying to hoover up after the Christmas tree has been taken down on the twelfth night. That is everytime I think I have finished another needle magically appears ! I have now resolved top write up what I have done so far and treat it as a work in progress / first draft and let me have any comments you may have so that I can develop it further. So here goes !

The Background

Bradford & Bingley Building Society was formed in 1964 as a result of the merger of the Bradford Equitable Building Society and the Bingley Building Society, both of which were established in 1851. The Society floated on the London Stock Exchange on 4 December 2000 and Bradford & Bingley plc was formed.

On 27 September, the Financial Services Authority informed Bradford & Bingley that it no longer satisfied their conditions for operating as a deposit taker, and on 29 September, in order to promote financial stability and to protect consumers, HM Treasury took ownership of Bradford & Bingley in accordance with The Bradford & Bingley plc Transfer of Securities and Property etc Order 2008 and sold the UK and Isle of Man retail deposit business to Abbey National plc for £611 million.

At the point of the Transfer, Bradford & Bingley held total assets of £52.5bn, including loans and advances to customers of £42.2bn, of which £41.3bn were residential mortgages and £0.9bn were commercial and housing property loans. These assets were funded by a range of wholesale funding vehicles (securitisations, covered bonds and unsecured wholesale funding) representing liabilities of £28.4bn and retail deposits of £20.4bn, including £1.4bn in the Isle of Man business. In accordance with the terms of the Transfer Order, 1,684 employees of Bradford & Bingley transferred to Abbey, as well as 197 branches (160 leasehold and 37 freehold) and 140 agency branches (franchises).

The retail deposits transferred to Abbey were replaced simultaneously with a Statutory Debt (the ‘Statutory Debt’) totalling £18.4bn owed to the FSCS.  Simultaneously, HM Treasury provided a guarantee with regard to certain wholesale borrowings and derivative transactions with the Company existing at the time of the Transfer.

In addition to the £42.2bn loans and advances to customers, Bradford & Bingley also held £7.9bn of wholesale assets, comprising loans to central banks and other banks and debt securities in issue. The balance sheet value of derivative assets was £2.1bn, primarily associated with the fair value of cross currency and interest rate swaps used to reduce risk on the balance sheet. The remaining £0.3bn assets were fixed and other assets.

Immediately following the Transfer, Bradford & Bingley’s balance sheet was primarily financed by wholesale funding and the Statutory Debt. In addition, Abbey continued to provide a loan of £1.6bn to Bradford & Bingley in respect of the Isle of Man deposit business it had acquired. The remaining liabilities consisted of £1.5bn subordinated debt and other capital instruments, £1.5bn
equity and reserves, and £0.9bn of derivative and other liabilities.

Following the Transfer, the Group was required to cease new lending activities immediately. Other than honouring outstanding mortgage commitments, the business was transformed from a mortgage and deposit taking bank into a mortgage servicing bank, with ongoing obligations in the wholesale money markets, to HM Treasury, the FSCS and to Abbey in servicing the retail deposit business and branch network.

The Subordinated Bonds

Table of Bradford & Bingley Subordinated Bonds

Financial Position

1.    Balance Sheet Value

2.    Future Earnings

Bradford & Bingley Business Plan

And goes on to say that:

In order to achieve its objectives, Bradford & Bingley will pursue the following strategic priorities:-

1.    Run down the balance sheet in an orderly fashion over a number of years:
- Cease new lending
- Run down the mortgage book through redemptions and loan sales where appropriate
- Run down or sell the commercial loan book and other wholesale assets
- Run down the mortgage book through redemptions and loan sales where appropriate
- Run down or sell the commercial loan book and other wholesale assets

2.    Minimise impairment and losses:
- Manage mortgage arrears through an active collections strategy
- Increase focus on collections from larger portfolio landlords
- Offer a range of options to customers facing payment difficulties
- Minimise losses and pursue recoveries

3.    Restructure and re-align the business to its new, more focused objectives:
- Reduce costs
- Manage the impact on the community
- Develop a new operating model

4.    Provide transitional services to Abbey for up to 18 months from the date of the Transfer to support the transferred branch and deposits business

Q350 Mr Brady: How much influence have the authorities had over the day-to-day running of Bradford & Bingley?

Mr Pym: Since nationalisation?

Q351 Mr Brady: Yes.

Mr Pym: We have worked very closely with the Treasury and the shareholder executive, and not just myself but there is a whole team of people who are working all the time with the Treasury team to develop this business plan, and contact is very, very frequent, and very, very constructive. We are working with some high-quality people.

Q352 Mr Brady: So you are working closely on a business plan. Would you describe the relationship in operational terms as arm's length?

Mr Pym: Yes, but it is quite clear what I have to refer to them on. We are aware of their areas of sensitivity and where they do want to get involved, and that is clearly laid out in the framework agreement.

Q353 Mr Brady: How often each day would any of you speak to the Treasury?

Mr Pym: I guess there is someone talking to the Treasury ever day. My meetings are fortnightly, but with telephone calls in between.

The Valuation / Compensation Process

As discussed above the terms of the dated subordinated bonds were varied significantly by the Transfer Order and, in particular, the terms of the 2010 bonds have been altered such that non-payment of interest or non-redemption on the due date is no longer an event of default. Coupons on both this bond and also on the undated bonds have been suspended, and it has been announced that the 2010 bond will not be redeemed on its due date. As a result, all these bonds are now trading in the market at a small fraction of their par value. Nationalisation has clearly led to losses on the 2010 bonds (which would otherwise have been due for redemption in February 2010), and also on the undated bonds because even though their terms allow coupons to be deferred, in practice deferral is only taking place due to the events consequent on nationalisation. Immediately following nationalisation, HMG forced B&B to sell its £20bn+ deposit loan book to Santander and replaced this source of funding with the Statutory Debt. Coupons on the various bonds have been suspended in order to prioritize the repayment of this Statutory Debt, and the B&B business has been placed in run down. In summary, it is clear that events post nationalisation have adversely affected the interests of all bond holders.

At the time of nationalisation, B&B was eligible to participate in the Bank of England’s Special Liquidity Scheme. This scheme, introduced in April 2008, was open to all UK banks and building societies “which are eligible to sign up for the Bank’s Operational Standing Facilities”. It was therefore a part of the Bank’s Standing Facilities, which the BoE’s own website describes in part as follows: “Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances, they carry a penalty, relative to the Bank’s official rate, of +/- 25 basis points on the final day of the monthly reserves maintenance period and of +/- 100 basis points on all other days.”

It seems clear that the SLS scheme, which was publicly announced as available as part of the Bank’s Standing Facilities, should have been available to B&B in September 2008. Under the scheme (which continued in force until January 2009 and under which the BoE provided £185bn of liquidity support across the UK banking sector) eligible institutions (which included B&B) were able on to swap covered mortgage backed bonds for liquid UK Treasury Bills. It has been reported that, on the morning of nationalisation, B&B had suffered deposit withdrawals of approximately £200m, but (even if this were true) it is not at all clear to me why the BoE appears to have refused B&B access to the SLS to cover this amount, which was relatively minor in the context both of B&B’s £20bn+ deposit base and £40bn+ mortgage book. Even in the absence of BoE facilities, it would have been open to B&B to dispose either of some of the listed debt securities it held (over £4bn at the end of 2008, including almost £1bn of government securities) or even of some of its prime mortgages. Assuming the worst case of B&B having to dispose of some of its prime mortgages, and considering that the Northern Rock valuer has applied a notional discount of 15% when estimating at what price Northern Rock could have disposed of mortgages. Applying a similar discount in B&B’s case would imply that £230m of mortgages could have been sold for £200m to cover deposit withdrawals. The resultant £30m of losses could comfortably have been absorbed within B&B’s £1bn plus shareholders’ funds, leaving B&B as a viable on-going business.

As the Valuer highlighted in his letter to B&B shareholders earlier this year, the Banking Act 2008 requires that in determining compensation you should assume “that all financial assistance from the Bank of England or HM Treasury had been withdrawn and that they would not provide any in the future (apart from ordinary market assistance offered by the Bank of England subject to its usual terms)”. It seems clear that the SLS constituted “ordinary market assistance” at that time as it was a publicly announced liquidity support programme which constituted part of the Bank’s Standing Facilities available to all eligible UK banks and building societies (what else could “ordinary market assistance” mean other than the Bank’s Standing Facilities?). It could therefore be argued that the Valuer should not assume, for valuation purposes, that the BoE would refuse to allow B&B access to its Standing Facilities, even though they in fact appear to have done so and forced nationalisation.

This point is given added force by a statement made by Lord Myners in a House of Lords debate on 15th December 2008, when debating the B&B compensation order:

When taken into public ownership in February 2008, Northern Rock had been in receipt of substantial institution-specific financial assistance for over five months, in the form of both loans from the Bank of England and the provision of Treasury guarantee arrangements. By contrast, no such guarantee arrangements had been provided to Bradford & Bingley, and the Bank of England had provided no loan facilities to it that were not also open to all qualifying institutions. As a result, it is right to impose no further assumptions beyond the mandatory assumptions under the Banking (Special Provisions) Act 2008. It will be for the valuer to assess the implication of those assumptions.

From the above it is quite clear that the position of B&B differs markedly from that of Northern Rock. B&B appears to have been solvent at the point it was nationalised, and hence the Valuer does not have to assume that the business was in administration for valuation purposes. At the time of nationalisation it had positive ordinary shareholders’ funds of over £1bn, and subsequently as at June 2009 it still had positive shareholders’ funds of over £1bn. The UK Government appears to have nationalised B&B pre-emptively in fear that it might become vulnerable to large scale withdrawal of retail or wholesale deposits, but that had not occurred at the point of nationalisation. That is the government’s right under statute, but statute also says that in these circumstances compensation must be paid if thereby ordinary shareholders or bond holders have suffered loss.

There is therefore a case that B&B bond holders should receive compensation. In the case of the 2010 bond the amount of compensation payable is particularly clear, since in the absence of nationalisation those bonds would have fallen due to be redeemed at par in February 2010, and in the meantime coupons would have been mandatorily payable as normal. The loss suffered in respect of the undated bonds is more difficult to quantify since they are undated, and even prior to nationalisation their coupons were legally deferrable. Nevertheless, it is clear that the decision to defer coupons was in fact taken as a consequence of nationalisation in order to prioritize repayment of the statutory debt, and this has caused loss of income and a sharp fall in their market price. It can be argused that the compensation for this should comprise coupon payments being brought up to date and resumed. Were this to happen, no loss would have been suffered by undated bond holders.