Granite: a pact
Cerberus has given the UK government a rapid way of shrugging off its Northern Rock albatross. The private equity firm on Nov. 13 bought 13 billion pounds’ worth of mortgage assets from the bust UK lender’s main securitisation portfolio, Granite. Both sides get something out of it, but Cerberus may be getting the better end of the deal.
In the wake of the global financial crisis, the UK had to put 22 billion pounds into Northern Rock to replace the wholesale funding that had suddenly dried up. After the 5.5 billion pounds Cerberus will pay to UK Asset Resolution, the state entity in which Northern Rock mortgages now sit, the remaining loan will stand at 8 billion pounds. That helps the government with its deficit reduction programme.
Cerberus plans some energetic refashioning of Granite’s capital structure. Almost two-thirds of it is funded via bonds, with the rest as equity. The private equity firm will collapse this structure, pay off the bondholders in full, and refinance off its own bat – presumably via bank loans. That’s quite a risk, given that over half Northern Rock’s remaining mortgages are equivalent to more than 75 percent of the value of homes that back them.
To offset the price, Cerberus will sell 3.3 billion pounds of loans on to TSB, a UK bank. Its return therefore hinges on the speed at which the remaining 10 billion pounds of assets are repaid plus the average yield on them. Out of that comes the cost of funding and the volume lost when mortgage holders don’t repay.
The maths work thus. Assume Cerberus funds the same 35 percent of its mortgages in equity, and that 6 percent of them get repaid each year. If it can receive the same 4.79 percent yield recorded on Granite assets in April, can fund said assets at 2 percent a year, and its 8 percent bad debt ratio gets no worse, it could make a 7 percent internal rate of return on the assets annually over five years, according to Breakingviews estimates.
If bad debts soar, or Cerberus’ funding costs are much higher, this will obviously be lower. Equally, it can improve its return by leveraging up. But given that UKAR will keep on servicing these mortgages – and 7 percent would be a pretty good return for Granite’s current government shareholders – taxpayers might wonder if they could have just hung on to the assets a bit longer.