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Global Research

Credit
UK - Banks Northern Rock
What will happen to the sub?
 Nationalisation of a UK bank, unprecedented

 The fate of the different tiers of sub very unclear

 The outcome is quite likely a political decision

Sketching scenarios
On Sunday afternoon Chancellor Alistair Darling announced the nationalisation of
Northern Rock. Yesterday Prime Minister Gordon Brown announced the introduction of a
law to nationalise NR, signalling that the long-sought private sector solution has for now
been deemed impossible. Such a nationalisation is an unprecedented move for a UK bank.
Mr Darling insisted that business would continue “as usual” for NR under the stewardship
of newly appointed Ron Sandler (as executive chairman), who turned around Lloyd’s of
London in the 1990s.

It is clear that the government’s main goal is to preserve taxpayers’ money but Mr Darling
also said that all the existing guarantees will remain in place.
19 February 2008
All subs are unguaranteed. At this stage it is very difficult to predict what will happen to
Carlo Mareels*
them as this is now much more a political decision than a business decision. We believe
Senior Analyst (Banks & Insurance)
HSBC Bank Plc that the UK government hasn’t fully made up its mind on this. In our view the ultimate
+44 207 991 6722 outcome will depend on how quickly the government decides it wants its money back and
carlo.mareels@hsbcib.com
whether this involves a fire sale of assets or not. The government/NR has a couple of
Oliver Burrows *
routes it can undertake from here. We’ll take a quick look at these. At present the
Analyst (Banks & Insurance)
HSBC Bank Plc government wants to keep the bank running as a going concern aiming at re-privatising
+44 207 991 5632 NR “when the conditions will allow for it” (ie no winding down of the operations).
oliver.burrows@hsbcib.com
Theoretically this should give some form of comfort to holders of sub paper as
antagonising the wholesale market would be counter-productive if it is needed to privatise
View HSBC Global Research at: NR again. On the other hand there is no clear commitment, so far, by the government or
http://www.research.hsbc.com
the bank to stand by its subordinated debt holders. There are not enough elements at this
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and is not stage to make a call on coupon and principal payment of the subordinated bonds of
registered/qualified pursuant to NYSE
and/or NASD regulations
Northern Rock
Issuer of report: HSBC Bank plc We cannot predict the outcome of this situation and the consequences for the different
Disclaimer & tiers but we can try to take a look at the assets and build up 3 scenarios (benign, median
Disclosures and conservative) all with different asset valuations and how the different capital tiers
This report must be read would be impacted under each of them.
with the disclosures and
the analyst certifications in
the Disclosure appendix,
and with the Disclaimer,
which forms part of it
 Credit
UK - Banks abc
19 February 2008

Existing guarantees remain in place

On Sunday Chancellor Alistair Darling announced the nationalisation of Northern Rock. Yesterday Prime
Minister Gordon Brown announced the introduction of a law to nationalise NR, signalling that the long-
sought private sector solution has now been deemed impossible under the present market circumstances.
Such a nationalisation is an unprecedented move for a UK bank. Mr Darling insisted that business would
continue “as usual” for NR under the stewardship of Ron Sandler.

It is clear that the government’s main goal is to preserve taxpayers’ money but Mr Darling also said that
all the existing guarantees will remain in place.

As a reminder, the guarantees cover:

 all uncollateralised and unsubordinated wholesale deposits and other borrowings

 all payment obligations of Northern Rock plc under any uncollateralised derivative transactions
(Senior and Sub CDS counterparty)

 all collateralised derivatives and all wholesale borrowings which are collateralised (including without
limitations the covered bonds) to the extent that those obligations exceed the available proceeds of
the realised collateral

 all obligations of Northern Rock to make payments on the repurchase of mortgages under the
documentation for the "Granite" securitisation programme

If anything all the guarantees on senior unsecured, which were granted on a temporary basis, are now being
reinforced by the nationalisation as this takes some of the “temporary” character of the guarantee away.

In a press conference yesterday morning the Prime Minister and the Chancellor stated again that this
solution is seen by the government as a “temporary nationalisation” only. The aim would be to return NR
to the private sector when the market situation allows. We add here that this is not necessarily easy.

But what about the unguaranteed debt?

All subs are unguaranteed. At this stage it is very difficult to predict what will happen to those as this is
now much more a political decision than a business decision. We believe that the UK government has not
fully made up its mind on this. We have no new information at this stage apart from Mr Darling saying
that business would "continue as usual", whatever that may mean in the case of Northern Rock.

In our view the ultimate outcome will be how quickly the government decides it wants its money back
and whether this involves a fire sale of assets or not. At this stage the latter seems not to be the most
likely scenario. The government/NR has a couple of routes it can take from here. Ultimately, despite the
stated aim of only a temporary nationalisation, the government’s decisions, and the speed at which these
decisions are taken, will be driven by the market, ie 1) banks’ and other wholesale market participants’
willingness to provide liquidity to a weaker counterparty; 2) willingness of depositors to leave their
money with NR; and 3) valuation of the assets.

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 Credit
UK - Banks abc
19 February 2008

Possible paths, all with different risk implications for sub paper:

 It can let NR let go into bankruptcy or break it up with the aim of recovering enough value from the assets
to repay the Bank of England, the depositors and probably all the liabilities it decided to guarantee.

This route looks very unlikely at this stage. This would be the worst-case scenario for the subordinated
bondholders.

 It can let NR run off its assets, which would gradually allow the bank to repay its creditors. This
would rapidly see a shrinking of the balance sheet. Should markets improve at some point in 2H08 or
in 2009 it could also contemplate the sale of some assets.

This would be probably the easiest and quickest way to get all the money lent to NR back. However, the
government will likely want to avoid this as it would likely mean the end of Northern Rock as a
significant bank, with all the consequences in terms of job losses.

This option still leaves the door open for a potential reprivatisation of NR, albeit a very reduced NR,
if/when NR can be funded by the market again at levels that allow it to make profits on new business. The
main risk here is if, during the rolling off process, a deterioration in asset quality were to occur,
necessitating write-downs. By the last accounts (1H07) the equity portion of the capital was just under
GBP1.9bn. This means that any write-down beyond this figure would dent the Tier1 bonds.

This route would be likely to lead to no losses (or limited losses) on the subs. This is because there is little point
in letting the wholesale investors down if there is still hope to save the bank and eventually IPO it again.
Obviously the likelihood of anything being called would depend on what the capital needs will be at the call
date (very likely much lower than today) and the availability of cash to pay them back to the holders.

 Finally, a nationalised Northern Rock could try to regain momentum and compete vigorously (as
stated by Mr Sandler yesterday in a press conference) to increase its margins by originating new
mortgages at better spreads. This would mean that the bank’s assets would shrink at a much slower
pace. The size of the bank would likely shrink much less than in the option above. Probably the pace
at which the bank repaid its debt to the Bank of England would be also much slower.

We understand that a nationalisation is justified in order to protect taxpayers’ money and depositors. A
roll down of assets should be sufficient for this. We don't see, however, how the government could justify
attempts by the bank to originate new business as this would be done at better funding levels (given that it
would now be government risk) than even the best competitors could achieve. This would raise a quite
significant competition problem. However, given that this is a highly political situation, it could well be
that if NR kept a relatively low profile in terms of new mortgage lending market share, versus previous
15% +, the competing banks would allow a certain degree of government support. Should NR and HM
Government be allowed to do this, it would also increase the odds of sub capital to continue to pay all of
its coupons (as recently reiterated with the coupon payment of the USD pref shares) as well as principal.
All still quite early to call.

3
 Credit
UK - Banks abc
19 February 2008

Scenario building in case of accelerated wind down

We cannot predict the outcome of this situation and the consequences for the different tiers but we can try
to take a look at the assets and build up 3 scenarios (benign, median and conservative) all with different
asset valuations and assess how the different capital tiers would be impacted under each one of them. All
the results are in the tables below.

We consider for the purpose of this exercise only the assets that are on balance sheet, ie ex-securitisation.
We also took out the GBP10.29bn in covered mortgages (at end June 2007).

In our benign scenario the assets would see a drop in value of about 5.2% to GBP50.1bn, in a median
case wind-up scenario the drop in value would be 5.9% to GBP50bn and in a conservative scenario the
drop would be 7.9% to GBP48.7bn. One could argue that even more conservative scenarios could be
contemplated but it is our goal here to give a framework. Readers can make their own assumptions about
the eventual haircuts.

Scenario analysis with different haircuts, GBP bn, % changes in the value of the assets after
Assets As Benign Median Conservative Benign Median Conservative %change in asset value
reported (Sale (wind-up (sale (wind-up post haircut
30-Jun-07 Haircut) haircut) recovery) recovery)
mortgages ex covered 21,156 5.0% 5.0% 7.0% 20,098 20,098 19,675
bond collateral
BTL mtges 6,072 5.0% 5.0% 10.0% 5,768 5,768 5,464
commercial lending 342 5.0% 7.0% 10.0% 325 318 308
unsecured lending 8,448 10.0% 12.5% 15.0% 7,603 7,392 7,181
subtotal: lending 36,018 - - 33,794 33,576 32,628 6.2% 6.8% 9.4%
AFS 7,400 - - - - -
AAA AFS 35% 2,590 2,590 2,590 2,590
AA AFS 31% 2,294 2,294 2,294 2,294
A AFS 25% 1,850 1,850 1,850 1,850
BBB AFS 9% 666 666 666 666
SIV capital notes bank 305 75% 90% 100% 76 31 0
sponsored
SIV capital notes non 20 100% 100% 100% 0 0 0
bank
AAA direct Sub prime 75 0% 50% 100% 75 38 0
exposures
US CDO 178 50% 75% 100% 89 45 0
SIV Lites 22 100% 100% 100% 0 0 0
Total AFS 8,000 - - 7,641 7,513 7,400 4.5% 6.1% 7.5%
cash 768 0.0% 0.0% 0.0% 768 768 768
derivatives 1,433 0.0% 0.0% 0.0% 1,433 1,433 1,433
banks loans 6,812 0.0% 0.0% 0.0% 6,812 6,812 6,812
fair value adjustments (836) 0.0% 0.0% 0.0% (836) (836) (836)
for hedging
Financial assets at fair 119 20% 25% 30% 95 89 83
value
intangible assets 101 100% 100% 100% 0 0 0
property, plant & 216 0% 0% 0% 216 216 216
equipment
deferred tax asset 5 0% 0% 0% 5 5 5
other assets 34 100% 100% 100% 0 0 0
retirement benefit asset 13 0% 0% 0% 13 13 13
prepayments and 183 0% 0% 0% 183 183 183
accrued income
subtotal other assets 8,847 8,689 8,683 8,677 1.8% 1.9% 1.9%
Total Assets 52,865 - - 50,124 49,772 48,705 5.2% 5.9% 7.9%
Source: HSBC estimates, company accounts

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UK - Banks abc
19 February 2008

Now what does this do to the valuation of the subordinated bonds shown in the table below?

Outstanding institutional subordinated NRBS bonds

type Issuer ISIN next call coupon
Non-step Saphir XS0259175536 04-Jul-16 6.8509
TONs NRBS plc XS0152710439 21-Sep-27 7.053
RCIs NRBS plc XS0117031194 21-Sep-15 8.399
UT2 NRBS plc XS0098556961 17-Jun-24 6.75
UT2 NRBS plc US66567FAA03 28-Jun-17 6.594
UT2 NRBS plc US66567EAW57 30-Apr-14 5.6
LT2 NRBS plc XS0070077010 17-Oct-21 9.375
LT2 NRBS plc XS0157198937 13-Jan-10 5.625
LT2 NRBS plc XS0143152337 28-Feb-12 5.75
Source: HSBC, Bloomberg, company accounts

In all three of our scenarios the Tier 1 paper would be wiped out. This is also the case for the UT2 in the
conservative scenario. However, in the benign and median scenarios the UT2 would be, respectively,
fully recovered (GBP1.1bn) or partially (GBP783m) recovered. Obviously LT2 would be able to see a
full recovery in the benign and median scenarios but in our conservative scenario there would be only
GBP466m left to pay to LT2 holders.

Capital impact in different scenarios

impairment actual (2,741) (3,093) (4,160)
Tier 1 capital 1,876 residual after hit 0 0 0
Tier 1 bonds 900 34 0 0
total Tier 1 2,776
UT2 1,100 1,100 783 0
LT2 750 750 750 466
total subordination 4,626
Source: HSBC estimates, company accounts

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 Credit
UK - Banks abc
19 February 2008

Disclosure appendix
Analyst certification
The following analyst(s), who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject
security(ies) or issuer(s) and any other views or forecasts expressed herein accurately reflect their personal view(s) and that no
part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained
in this research report: Carlo Mareels and Oliver Burrows

Basis for financial analysis

This report is designed for, and should only be utilised by, institutional investors. Furthermore, HSBC believes an investor's
decision to make an investment should depend on individual circumstances such as the investor's existing holdings and other
considerations.

HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which
depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations.
Given these differences, HSBC has two principal aims in its credit research: 1) to identify long-term investment opportunities
based on particular themes or ideas that may affect the future earnings or cash flows of companies on a six-month time
horizon; and 2) from time to time to identify trade ideas on a time horizon of up to three months, relating to specific
instruments, which are predominantly derived from relative value considerations or driven by events and which may differ
from our long-term credit opinion on an issuer. HSBC has assigned a fundamental recommendation structure only for its long-
term investment opportunities, as described below.

HSBC believes an investor's decision to buy or sell a bond should depend on individual circumstances such as the investor's
existing holdings and other considerations. Different securities firms use a variety of terms as well as different systems to
describe their recommendations. Investors should carefully read the definitions of the recommendations used in each research
report. In addition, because research reports contain more complete information concerning the analysts' views, investors
should carefully read the entire research report and should not infer its contents from the recommendation. In any case,
recommendations should not be used or relied on in isolation as investment advice.

Definitions for fundamental credit recommendations

Overweight: The credits of the issuer are expected to outperform those of other issuers in the sector over the next six months

Neutral: The credits of the issuer are expected to perform in line with those of other issuers in the sector over the next six
months

Underweight: The credits of the issuer are expected to underperform those of other issuers in the sector over the next six
months

Prior to 1 July 2007, HSBC applied a recommendation structure in Europe that ranked euro- and sterling-denominated bonds
and CDS relative to the relevant iBoxx/iTraxx indices over a 3-month horizon.

Distribution of fundamental credit opinions

As of 18 February 2008, the distribution of all credit opinions published is as follows:

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 Credit
UK - Banks abc
19 February 2008

___All Covered Companies___ Companies where HSBC has provided Investment Banking in the past 12 months
Count Percentage Count Percentage
Overweight 86 22 23 27
Neutral 187 49 39 21
Underweight 114 29 19 17
Source: HSBC

Analysts are paid in part by reference to the profitability of HSBC which includes investment banking revenues.

For disclosures in respect of any company, please see the most recently published report on that company available at
www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
1 This report is dated as at 19 February 2008.
2 All market data included in this report are dated as at close 15 February 2008, unless otherwise indicated in the report.
3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research
operate and have a management reporting line independent of HSBC's Investment Banking business. Chinese Wall
procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or
price sensitive information is handled in an appropriate manner.

7
 Credit
UK - Banks abc
19 February 2008

Disclaimer
* Legal entities as at 22 August 2007 Issuer of report
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Corporation Limited, Hong Kong; 'TW' HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC
Securities (Canada) Inc, Toronto; HSBC Bank, Paris branch; HSBC France; 'DE' HSBC Trinkaus & 8 Canada Square, London
Burkhardt AG, Dusseldorf; 000 HSBC Bank (RR), Moscow; 'IN' HSBC Securities and Capital Markets E14 5HQ, United Kingdom
(India) Private Limited, Mumbai; 'JP' HSBC Securities (Japan) Limited, Tokyo; 'EG' HSBC Securities Telephone: +44 20 7991 8888
Egypt S.A.E., Cairo; 'CN' HSBC Investment Bank Asia Limited, Beijing Representative Office; The Fax: +44 20 7992 4880
Hongkong and Shanghai Banking Corporation Limited, Singapore branch; The Hongkong and
Website: www.research.hsbc.com
Shanghai Banking Corporation Limited, Seoul Securities Branch; HSBC Securities (South Africa)
(Pty) Ltd, Johannesburg; 'GR' HSBC Pantelakis Securities S.A., Athens; HSBC Bank plc, London,
Madrid, Milan, Stockholm, Tel Aviv, 'US' HSBC Securities (USA) Inc, New York; HSBC Yatirim
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HSBC, HSBC Bank Brasil S.A. - Banco Múltiplo.
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