Since I started this site a number of users have contacted me asking for research on the position of Northern Rock subordinated bonds. I was not keen to undertake this task because I did not think it likely that there was any value to be found. However, recent events have at least persuaded me to take a look. In particular the announcement that the 'rump' of Northern Rock (Northern Rock Asset Management - 'NRAM')  was to be put under the same Chairman (Richard Pym) and holding company as Bradford & Bingley (B&B) and then the simultaneous announcement of tender offers for various issues of subordinated notes of NRAM on near identical terms. This suggests that NRAM and B&B are effectively being run as one and that bond investors are likely to receive the same discretionary treatment in future.

While that provides some encouragement the balance sheet and earnings prospects of NRAM are not as attractive as B&B. This is largely because a large part of B&B's state funding is interest free whereas NR's is all interest bearing. However, the terms of the recent split of NR into a continuing bank (Norhern Rock plc) and a rump which is being rundown (NRAM) may have made NRAM a more attractive proposition. For example HMG have committed to convert £1.6 billion of its debt in NRAM to equity if necessary in a stress test scenario.

 

Another positive has been the outcome of the June 2010 tender offer which I has resulted in a profit of £780 million for NRAM on repurchase of subordinated notes with face value of £1,082.7 million. This, together with HMG's contingent £1.6 billion debt for equity exchange adds a useful cushion beneath subordinated debt in the balance sheet. The 31 Dec 2009 accounts showed negative shareholders equity of £386 milion but the £780 million repurchase gain together with an interim profit of £359 million turned this to a positive of £835 million at 30 June 2010. Despite being the 'bad bank' part of the split NRAM announced a 2010 interim trading profit (the 'good bank' reported a loss) of £359 million. However this includes a one off gain of £152 million and I would expect the cost base to reduce significantly through the economies achieved from much of the rundown administration being performed by B&B in future.

 

 

 

Somewhat controversially NRAM was not compensated, under the split, for the loss of the goodwill which has gone with the continuing bank. I would be surprised if the creditors left in NRAM would have accepted a transfer of assets at undervalue but it is also possible that the Statutory Instrument used to implement the split removed their rights to act. This point was picked up upon by the formidable Baroness Noakes in a House of Lords debate on the restructuring. The Hansard record of this 27 January 2010 debate on the restructuring of Northern Rock:

 

 The outstanding subordinated bonds following the tender offer are summarised in the following table:

 

In terms of investment opportunities the high take up (around 80%) of the recent tender offer has left the issues included with a pretty small and illiquid rump. The main issues which were not tendered for are:

£20M 11.625% former PIBS
£200M 7.053% Tier 1 Notes
£300M 8.399% Reserve Capital Instruments

The former PIBS are a smallish retail issue and hard to find in any volume. I was suggested the 8.399% RCI's as an alternative and have taken a look. The terms are somewhat exotic. They are cumulative and can be deferred in 2 ways as follows:

1. Deferral on grounds of capital adequacy. In this case interest is accrued but not compounded.

2. Deferral on discretion. In this case interest is accrued and interest is levied on the deferred interest at 10.399%.

Deferral to date on both the RCI's and Tier 1 Notes has been on the grounds of capital adequacy. but I do not think NRAM will be in the position to do this in future do to its increased equity and the D4E commitment given by HMG.

All deferred interest must be settled before any payment can be made to shareholders.

From here things get really interesting. This is because, under the terms of the RCI's, all deferred interest must be settled by way of an ACSM. However, the ACSM is for the issue of ordinary shares to cover the quantum of the deferred interest. The nationalisation of NR clearly makes this impossible. Hence the Transfer Order made an amendment to the terms such that while in public ownership HMT may elect to settle the interest directly in cash (in which case HMT is issued with RCI's to the value of the cash) or HMT may elect that sufficient RCI's are issued to the trustee to raise the cash necessary to cover the interest. I very much doubt there would be a market for the the RCI's to enable the second option. This means that the RCI's could be a bit of a headache for HMT in future as they could end up having to settle the deferred interest directly before they can get anything back on their shares. This is all uncharted territory but it could well be that the complications are sufficient for HMT to be minded to clear up the RCI's as part of a future liability management exercise.

 

To download the full prospectus for the RCI's see the link in the references section at the bottom of this page.

 

 

Northern Rock Asset Management have announced that they are deferring the coupon due on 21 September on the 8.399% RCI's in accordance with condition 4(b) of the terms. This means that interest should accrue on this deferred coupon at the rate of 10.399%. Full announcement at:

 

 

The Financial Times have reported that Northern Rock Asset Management is hoping to repay about two-thirds of its £22.5bn government loan within the next five or six years as it looks to sell portfolios of mortgages rather than simply rely on borrowers repaying their debt.

 

 

NRAM have announced that announced that UK Asset Resolution Limited (“UKAR”) has been established as the new holding company for NRAM and Bradford & Bingley plc. It seems that NRAM and B&B will remain as separate legal entities but that the new structure has been put in place to facilitate the most efficient rundown of both the NRAM and B&B mortgage books. Hopefully the resulting efficiencies will result in cost savings going forward.

Of more immediate interest are the comments made in the announcement about the recent performance of NRAM. In particular:

Since the restructure NRAM has made good progress, with financial performance improving. NRAM recorded a statutory profit of £350 million in the first six months of 2010 and added a further £780 million to shareholder funds through a debt buyback in the first half of the year. The positive underlying trend in operating performance has been maintained into the second half of the year. Repayments against the Government loan totalling £300 million were also made in the first six months of 2010. Additional repayments made since then have taken the total amount repaid so far during 2010 to £1 billion.

And:

Following the successful rescue and restructure of the former Northern Rock business, NRAM returned to profitability in the first half of 2010 as income increased, impairment charges were reduced and arrears continued to stabilise. This trend has continued in the third quarter and I feel NRAM is being handed over in good shape for the future.

Full announcement at:

 

 

 

It appears that NRAM quietly resumed payment of interest on its 7.053% Tier 1 Notes on the 21 September. However, it has continued to defer payment on the 8.399% RCI's which have the same interest payment date.  If one reads the terms of the Tier 1 Notes, the RCI's and the £400 million issue of preference shares which have been held by HM Treasury since nationalisation it does not seem legally possible for the Tier 1 Notes to pay while the RCI's are deferred. The reasoning is as follows:

 

1. The terms of the HM Treasury held 6.8509% Preference Shares contain a dividend restriction (stopper) which says that if the coupon is not paid on them then no distribution can be made on a Parity Obligation during the stopper period.

2. The Risk Factors of the 6.8509% Prefs specifically state that the 8.399% RCI's and 7.053% T1 Notes are Parity Obligations.

3. On 21 September 2010 a distribution was paid on the 7.053% T1 Notes. According to the Stopper I have referred to in (1) above this could not have been paid unless the last (4 July 2010) dividend had been paid on the 6.8509% Prefs.

4. The terms of the 8.399% RCI's contain a dividend restriction which says that while payment of coupons on the RCI's is deferred no dividend can be paid on any ordinary or preference shares - which must include the 6.8509% Preference Shares. But from (3) above it appears that this dividend must have been paid in order that the RCI coupon could be paid.

 

I have queried this with NRAM and a bit of probing eventually received a response. It appears that back in 2008 HM Treasury, as holder of the Preference Shares with the coupon restriction in their terms, agreed that coupons could be paid on the Tier 1 Notes and RCI's notwithstanding the restriction. The following is a link to the Notice was given on 3 July 2008:

 

 

 

Northern Rock (Asset Management) plc announces tender offers to holders of its outstanding £20,000,000 12.625 per cent. Perpetual Subordinated Notes (ISIN: GB0001524957), £300,000,000 8.399 per cent. Step-up Callable Perpetual Reserve Capital Instruments (ISIN: XS0117031194) and £200,000,000 7.053 per cent. Callable Perpetual Core Tier One Notes (ISIN: XS0152710439):

 

HM Treasury Northern Rock information page:

 

 

Final (7 May 2010) EC State Aid decision on Northern Rock:

 

 

Prospectus Terms of the Northern Rock 8.399% RCI's:

 

 

Trust Deed for the Northern Rock 8.399% RCI's:

 

Part 1: https://docs.google.com/viewer?a=v&pid=explorer&chrome=true&srcid=0B8hzbUJuMAkqZjZlYTIzY2QtZGQ5ZS00OWUwLWIyZjUtOGViNGY5YTUwMTRh&hl=en_GB

 

Part 2: https://docs.google.com/viewer?a=v&pid=explorer&chrome=true&srcid=0B8hzbUJuMAkqZDMxOWEzNzYtYjEwZC00N2RlLTkyZTItMmU1YjZjODExM2Q3&hl=en_GB