FYI | Sep 17 2007
By Greg Peel
The run on the UK’s fifth largest mortgage lender – Newcastle-based Northern Rock – continued in earnest in Saturday trading this weekend. While the first queues had formed outside branches across the country on Friday, by Saturday police were being called in to contain an angry mob. Northern Rock extended its usual closing time from 12pm to 2pm, but when doors ultimately closed on still-extensive queues, scuffles soon broke out. At other branches desperate depositors who had lined up from before dawn went away empty-handed as tellers simply ran out of cash. More queues are expected on Monday, and suggestions are that half of the lenders deposit base – GBP 12 billion – will be extracted by concerned small investors.
The run continued despite assurances from the Treasury and the Bank of England that deposits were secure. The BoE was forced to jump in and prop up Northern Rock against its previous indications. Just before the lender placed the emergency call, BoE governor Mervyn King had gone on record as saying bad practices in the lending industry should not be rewarded. But faced with a collapse of this magnitude, and a wide spread of British depositors small and large, the central bank was left with no choice. Now the finger pointing has begun.
The regulators are in the frame. Mervyn King faces a grilling from a parliamentary committee on Thursday. With the benefit of hindsight, critics are now asking how Northern Rock was allowed to increase its market share of UK mortgages from 2% a decade ago to 9% today. One in five mortgages signed in the last six months were provided by Northern Rock. New homebuyers were offered up to 125% on the value of their properties.
Since February this year commentators have tried to dismiss the global credit crisis as misplaced, given its origins in a very small part of the US lending market – subprime mortgages. While Northern Rock may have become a victim of the butterfly effect that saw a spate of US subprime foreclosures morph into a global liquidity freeze, such that the lender was unable to rollover finance on its outstanding loans, the crisis has revealed that subprime mortgages do actually exist elsewhere in the world. Northern Rock’s demise has followed similar rescues by the Bundesbank of two German lenders. In the US, the biggest mortgage lender Countrywide has twice been propped up by rescue packages from the private sector in the past month – one equity and one debt. European central banks are bracing themselves, waiting for the next dead fish to float to the surface. In the US, the Fed is preparing to make its monetary policy decision tomorrow. It may be that the Northern Rock experience influences a leaning towards a bigger cut. Commentators are already expecting the BoE to cut rates at the next meeting.
Just how long it will take for all the dead fish to float to the surface is another case in point. London asset manager Synapse Asset Management announced last week it was closing a US$300 million fund. The reason for the closure was not that the fund had been forced to book huge losses. The reason was that Synapse had entered into a bitter and untenable battle with its prime lender Barclays Capital as to just how the assets on its balance sheet should be valued. This example highlights the underlying problem of the asset-backed security market and the reason why banks have simply shut credit windows on suspicion. Under existing accounting rules funds are free to value their security holdings at just about whatever price they like, ignoring the fact that there is little to no market for them at present. They can do so in the hope that the credit crisis will eventually blow over, that rate cuts from the Fed and other central banks will quell the market, and that ultimately we can all pretend nothing ever happened. In the meantime, many a fund has frozen redemptions in the knowledge that any attempt to sell asset-backed securities will only lead to insolvency.
US investment banks begin reporting their third quarter results this week, after the September 18 decision from the Fed. Under US rules, the banks are obliged to mark their assets to market, but in the absence of any market they are able to mark to some assumed price. Will the world be satisfied that the true state of affairs is transparently revealed? Until financial institutions everywhere have opened all cupboards and exposed all skeletons financial markets will remain seized under a cloud of suspicion.
It would also be of great benefit to central banks if all were revealed. At least they would then know exactly what steps should be taken. The likelihood is that the Fed and its counterparts will remain reactive rather than proactive, in the typical nature of central banks, responding only to visible dilemmas. Central banks are caught between a rock and a hard place, because the most equitable way to resolve the credit crisis is to let those who should go under, go under. While UK regulators have come under criticism for allowing Northern Rock to paint itself into a corner, the BoE has also come under criticism for its bail-out.
The Times of London reports former BoE monetary policy committee member Willem Buitor as suggesting: “A bailout has occurred that should not have occurred and moral hazard has been injected into the financial markets – into the financial system – that wasn’t necessary.” It has not gone unnoticed by Wall Street that certain members of the FOMC hold a similar view in general.
Before the crisis even began, Northern Rock had been in talks with Lloyds TSB about a possible takeover of the lender. Australian banking industry newsletter The Sheet reports that National Australia Bank (NAB) has also had Northern Rock on its potential hit list as part of its UK expansion strategy. It is now most likely the lender will be broken up and sold off to any collection of bargain hunters, at least half of its deposit base having disappeared. An efficient economy is in operation when assets pass from weak hands to strong hands. The Willem Buitors of this world would have preferred the BoE not to have stepped Big Brother-style, thus setting off the desperate run on Northern Rock. Had the market been left to orchestrate a private rescue package – a la Countrywide – then it is likely all deposits would have been honoured. But could the BoE have taken this risk? As the Times reports, another former BoE insider, Sir Alan Budd, stated: “My general thoughts are that it is always easy to be wise after the event. I think Mervyn King and his colleagues will have been reluctant to offer assistance until they judged it was absolutely necessary.”
The Australian banking sector has not received the Northern Rock news well today. NAB, for example, is down 2% in afternoon trade. Wall Street was able to shrug off the news on Friday as traders squared up ahead of the 50 basis point rate cut they are assuming (hoping) will be forthcoming. Northern Rock may have just tipped the balance.
But if the Fed and other central banks are forced to act drastically, is this really good news?
(See also story “The Importance Of The Northern Rock Crisis Explained”, published earlier today).
