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Northern Rock bondholders brace for pain

June 16, 2009

The shareholders in Northern Rock have been wiped out, but all the various classes of bondholder have – so far – been paid out on time. That may be about to change. The European Commission is about to rule on the sensitive issue of the state aid poured into the failed bank nearly two years ago, and the UK government may offer to bite the bondholders as a quid pro quo for Commission approval.

Last week Fitch downgraded Northern Rock’s vast range of debts, arguing that the treatment meted out to Bradford & Bingley would be extended to the Rock. It seems likely that the Rock will be split into a legacy bank containing the 67 billion pounds of old mortgages, while the 20 billion pounds of deposits would go into a new bank.

The bonds would stay with the legacy bank, and the holders would have to bear the cost of the bad debts from old mortgages. According to The Times  today the Treasury has decided that the bondholders can take a haircut, which would reduce the amount of state aid the bust bank would need in future.

It hurts to say so, since I’m a Northern Rock bondholder, but this seems eminently sensible. The bonds at the bottom of the pile, confusingly called Tier 1, are risky, which is why they always yield more than those above them (confusingly called Tier 2). A blanket government guarantee on all the Rock’s debts would bring an unreasonable reward to the risk-takers.

The tougher question is whether the Tier 1 holders should be potentially wiped out before the Tier 2 holders suffer anything, as a strict legal interpretation implies. In practice, the legal niceties are subordinated to political reality, as we saw in the US with General Motors, and in the UK with Bradford & Bingley. A new Banking Act means that missing an interest payment  on subordinated debt is not an event of default.

It’s going to be painful. We just have to hope, as one unfortunate GM bondholder put it, that the haircut isn’t going to be a headcut.