Tuesday, 18 September 2007

Northern Rock Bailout - where is the outrage?

Every taxpayer in the United Kingdom should be outraged by the events of the last week.

For years, the Northern Rock has been gambling in the housing market. It offered ridiculous mortgages on overpriced property with scant regard for the consequences. So long as house prices kept rising, these risks were justified. Northern Rock shareholders were rewarded handsomely with appreciating share prices, while the senior management enjoyed scandalously large bonuses.

However, the UK housing bubble has just burst, and Northern Rock turned from being a moneymaking machine for reckless speculators into a financial disaster. The correct public policy response would have been to let this bank go into bankruptcy. It would have acted as a warning to all speculators that there are consequences to extravagant and arrogant risk-taking. The depositor base of Northern Rock was comparatively small, and given deposit insurance, small depositors would have received the bulk of their savings back. The management in other banks, who had taken a less irresponsible attitude to the housing market, would have been vindicated. In the fullness of time, prudent and careful banks would thrive, while speculators would learn a bitter but necessary lesson. Overall, the UK financial system would have benefited enormously from the demise of Northern Rock.

How did the Bank of England, the government and the Financial Services Agency (FSA) respond to this nasty little bank? It started rather well with the Governor of the Bank of England talking tough and promising that there would be no bailout of any troubled financial institutions on account of speculative activity in the housing market. Within 24 hours, this tough talk turned into a ridiculous parody. Northern Rock was running to the Bank of England begging for liquidity, and sure enough, our tough talking central bank were shovelling money into this financial wreck. The Financial Services Agency, who had scandalously neglected the activities of Northern Rock, approved the decision to supply an unlimited credit line and therefore avoiding bankruptcy.

The Bank of England and the financial services agency protested that Northern Rock was a fundamentally solvent bank. However, Northern Rock customers were a little smarter than the jokers running the Bank of England and the FSA. Customers have long pondered the advisability of offering loans amounting to 125% of house values. Customers had seen the extraordinary growth of Northern Rock and correctly assessed that the bank was rotten to the core. After all, if the bank was as healthy as the Bank of England and the FSA protested, why had other banks avoided offering emergency credit lines collateralised on the oh-so-wonderful Northern Rock loan portfolio? Many customers correctly realised that the best course of action was to immediately withdraw their deposits, knowing that the longer they waited, the greater the chance of losing their savings.

By Monday this week, the Chancellor and his fellow conspirators at the Bank of England and the FSA realised that the game was up. Northern Rock had degenerated into a full-scale bank run. Rather than take a principled stand against speculative behaviour in the financial sector, the Chancellor scandalously offered a blanket guarantee on all deposits held at Northern Rock. He backed up this guarantee with taxpayers money.

What will be the consequences of this guarantee? First, the speculators who held Northern Rock shares have done much better than they should have. Thanks to the Chancellor, Northern Rock shares enjoyed a 10% gain today. It guarantees that shareholders will not be wiped out and that they will recover some value from the bank. Whatever, the chancellor might say, this is a bailout of the shareholders.

Second, depositors who also speculated in the Northern Rock scam are also bailed out. This guarantee ensures that they will not suffer the consequences of banking in a ponzi scheme.

Third, it has destroyed completely the UK deposit insurance scheme. From now on, or bank deposits are implicitly guaranteed up to 100% by the government. In future, all depositors in troubled banks in the UK can legitimately ask the government "you bailed out Northern Rock, therfore you should bail out my bank".

Fourth, the moral hazard implications of this decision is frightening. All banks now understand that they can recklessly speculate in overpriced housing assets and know that if things go wrong, the government stands ready to bail them out. This will only serve to encourage further housing market speculation, which will ultimately create more damage.

However, Northern Rock is not the end of the story. It is barely the beginning of this dramatic financial crisis. UK Banks are hopelessly exposed to the housing market. That market is horrifically overvalued. Any slowdown will destroy these balance sheets. The Northern Rock bailout has created a precedent that the government will come to regret. Sooner or later, it will find itself pouring billions of pounds into the banking sector as the full consequences this open ended guarantee and the housing market bubble are realised.

In the end, the government will find itself diverting expenditure from health and education to housing market speculators. Of course, the government will try to hide this sorry spectacle. The bailout will take the form of an increase in public debt, which will be used to recapitalise the balance sheets of bankrupt banks brought down by defaulted mortgages. It will be the interest costs on these recapitalisations that will divert money from much-needed social expenditure.

Where is the outrage? This week, it was rather muted. However, as this consequences of this decision is understood, the public's mood will turn. The Northern Rock crisis is Gordon Brown's Black Monday. Like John Major's government, who lost all credibility after the ERM crisis, Brown and his chancellor are similarly damaged. Their credibility will not recover from this bail out.


Anonymous said...

This whole thing just makes me sick. The hypocracy just stinks.

George C said...

I don't mind the depositors getting their cash out, but the shareholders and management, this is a different matter.

Also, I hear that there are no buyers willing to take on Northern Rock. Maybe the Bank of England will end up owning the bank.

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