On Saturday, I outlined what I called the "seven steps to ruin". The following day, the UK government completed the course; it nationalized Northern Rock, taking over the ruinous debts of that insolvent bank.
Today, Brown and Darling were on TV reassuring us that everything would be fine. Even after all that has happened, there remains a mistaken belief that the government will pull something off and avoid losses. Well, it is time to wake up and face a stark reality. That is not going to happen. Northern Rock is going to hurt. The taxpayer will inevitably end up paying billions to cover the mistakes of private individuals speculating on real estate.
The numbers are most shocking aspect of the decision to nationalize Northern rock. The government now has some £100 billion of guarantees in place. UK public sector indebtedness will rise by around 6.7 percent of GDP. While some of that money will be recovered through asset sales, it is unlikely that this will generate sufficient amounts to cover the guarantees and loans that the government has sunk into this financial catastrophe since August.
However, the appalling magnitude of the numbers should not obscure the fact that the failure of Northern Rock was not a random event. It was not an accident that suddenly befell an unlucky bank caught in the summer credit crunch. The wholesale money market looked at the bank back in August and they did not like what they saw. Rather than put more money into the bank, creditors walked away, leaving the bank with insurmountable liquidity problems.
What scared the money market away? It was fears about the quality of Northern Rock's assets. Creditors feared that the bank had taken on too much risk. After all, this bank offered 125 percent loan to value mortgages while house prices was approaching its peak. The bank was also aggressively increasing its market share while other more prudent banks were pulling back.
In retrospect, the timing of Northern Rock's collapse was inevitable; the housing market peaked in July, and the Bank collapsed in August. The Northern Rock balance sheet did not make any sense; on the asset side, the bank had extended loans to purchase overpriced real estate. Many of these loans went towards financing the highly speculative buy-to-let market. On the liabilities side, the bank had financed these operations with short-term credits.
Those fears about asset quality have now become a matter of public policy. The taxpayer now owns Northern Rock and all its dubious mortgages. However, this could be just the beginning of a prolonged financial crisis. Northern Rock was not the only one pumping up Britain's preposterous housing market. Other banks could well follow Northern Rock into failure and public ownership.
The danger of a systemic financial sector meltdown should not be under-estimated. The UK financial sector managed to get into its current appalling mess without any help from the economy. Growth, at least up to the third quarter of 2007, was strong. Unemployment remains at historically low levels. Interest rates could hardly be described as high; With the RPI running at 4.1 percent, real rates are running at around 1 to 2 percent.
Yet despite this benign environment, banks are running up losses, while default rates are rising. What would happen to the UK banking sector if the economy began to slow? It is a question that is almost too appalling to consider.