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The Crisis at Northern Rock: Not Such a Wonderful Life?

In Frank Capra’s 1946 cinematic masterpiece ‘It’s a Wonderful Life’, George Bailey, owner of Bedford Falls’ local Building and Loan Association, is forced to contemplate suicide rather than face financial scandal and ruin.   His Uncle Billy misplaces $8000 of Society funds, bringing back dark memories of a previous financial crisis- one which caused local savers to queue round the block to get hold of their deposited money.  Opportunistic bank owner Henry Potter is unsympathetic, intent on gaining control of Bailey Building and Loan and putting an end to the "nonsense" of home loans for the working poor.  In the end, George is saved both by the intervention of a guardian angel and by emergency funding to the tune of $25,000, arranged via contacts in London.

Though not quite Hollywood material, savers with the UK’s Northern Rock building society must feel as if they’ve been living through some pretty dramatic scenes themselves during mid-September.  In the space of just three working days, around £2bn (out of a total of £24bn customer deposits) has been withdrawn by thousands of customers at NR branches around the country.  Such a ‘run’, once started, can be very difficult to stop as no saver wants to be among the last few to be paid out of what are perceived to be dwindling cash reserves.

Sub-Prime Panic: on an Exposed Rock

Northern Rock’s recent problems do not stem from its business becoming unprofitable, but through the seizing up of cash flow from the banks.  Unlike banks, NR lends money primarily for mortgages, financing this mostly through borrowing from banks and money markets- and therein lies the problem. 

By now, everyone should be familiar with the term ‘sub-prime mortgages’ and the havoc they have wreaked across the markets.  Over the past five years financial institutions hungry for commission and high rates of return bought and sold credit derivatives in a market that has grown from $1 trillion to $30 trillion since 2001.  Though superficially attractive, many of these derivatives turned out to be just fancy packages for extremely poor-quality debts when the music stopped earlier this year.  Loans to millions of people with poor credit histories, even wonderfully-named ‘NINJA’ loans (to people with ‘no income, no job or assets’) were all that backed these instruments up. 

Unfortunately for NR, all this has meant that the market’s appetite for financing mortgage risks has dried up in the past few months, effectively cutting off their commercial credit lines.  This has occurred even though there is no evidence that the NR loan book suffers from any significant quality issues- it seems the contagion of fear affects good and bad lenders alike.

In terms of basic liquidity, this isn’t a problem; just like the fictional George Bailey, NR can turn to London and borrow money directly from the Bank of England- which they did on September 13^th.  The Chancellor of the Exchequer Alistair Darling sought to calm the situation, commenting "in order to create a stable banking system, the Bank [of England] steps in and it makes facilities available to the Northern Rock.  Northern Rock can draw on them when it requires.  The problem here is there is a lot of money in the system but they [the banks] are reluctant to lend it to each other at the moment."

In real life, sadly, borrowing from the central ‘lender of last resort’ (as the BofE is sometimes referred to) tends not to be a happy ending; it only fuels speculation of imminent collapse and causes savers to panic- hence the long queues to withdraw funds. 

What are the Risks to Savers?

Are NR customers right to withdraw their cash, or are they panicking needlessly?  If the worst ever did happen, the UK financial system would not allow savers to sink without trace in the event of a bank going bust.  All banks (including NR) are covered by the Financial Services Compensation Scheme, insuring each individual saver as follows:

For example, a saver with £40,000 deposited at a UK bank has £31,700 guaranteed by the FSCS- 100% of £2,000 plus 90% of the next £33,000, but nothing for the last £5,000. 

However, in reality all this is fairly academic.  As all parties have been at pains to point out, there is no evidence to suggest NR is not a sound business at heart, once temporary cash flow issues are dealt with.  Indeed, in its present ‘distressed’ state (the share price having been through a virtual free-fall) NR has become a juicy target for takeover- industry insiders naming Lloyds TSB as one of several interested parties.  This would hardly be the case if the NR loan books were riddled with defaulters. 

In any case, on September 17^th Chancellor Darling stepped in to end all uncertainty, guaranteeing that the Bank of England would fully fund all NR savers’ withdrawals, should such funding be required.  

Was Northern Rock Built on Sand?

Many commentators have been keen to damp down fears of a breakdown across the whole banking system by pointing out that NR was unique in its reliance on mortgage business.  While some internal controls were no doubt in place, its central business model did seem to break one of the cardinal rules of banking- never borrow short to lend long.  NR’s mortgage borrowers are on 25-year repayments, while their savers have the right to withdraw funds on demand.  While the terms of NR’s borrowings from other banks aren’t clear, details of the BofE funding are definitely not for public consumption.

With NR directors and senior officers facing the glaring spotlight of publicity, questions are bound to be asked about whom knew what and when.  However, with both the Government and the British Bankers Association making sympathetic noises within hours of the crisis unfolding- and no savers actually losing money, serious regulatory or legal action seems unlikely.

Beyond NR: Shock Absorbers Required

Of course, plenty of other financial institutions have had their problems with the whole murky sub-prime business as well.  For example, Barclays Capital has reportedly lost up to £75m, plus a whole lot more in reputation, through direct trading in mortgage-backed credit derivatives.  However, the large banks with their multi-layered lines of business can always absorb shocks such as these without resorting to emergency measures- like appealing to the Bank of England for funding.

Modern financial markets have survived big shocks before now, such as the collapse of the massive derivative-based Long-term Capital Management fund in 1997.  However, investment gurus such as Warren Buffet continue to warn of the destabilising effect of the explosion of derivative trading over recent years.  In his 2003 letter to shareholders, he referred to derivatives as “mega-catastrophes” waiting to happen and as “financial weapons of mass destruction”.  The next few months will tell if the sub-prime crisis will serve as a fulfilment of his dire prophecy.  

In a neat film ending, the Bailey Building and Loan Association was saved overnight, in time for George Bailey to enjoy the Christmas festivities with his family.  Here in the harsh reality of 2007, things may not be as quick and simple for Northern Rock and its customers.