Monday, 18 February 2008

Northern Rock - Can it get any worse?

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.


Anonymous said...

Welcome to UK PLC the first European Banana Republic:

Anonymous said...

Yup, nationalisation is a terrible thing for banks. The government has had it's fingers so thoroughly burnt here that it's not going to bail out a second bank. They were caught boiling a frog on this one as their commitment gradually increased and more good money got thrown after bad.

I think history will show how lucky Northern Rock was to be the first. The second will be liquidated.

Northern Rock had two problems and it's important to separate them:

1) Liquidity - a natural consequence of borrowing short and lending long in order to pocket the difference in the yield curve. This is the basis of all banking and no big deal. In a liquidity squeeze they just post collateral at the BoE and borrow cash.

2) Solvency - a bank makes loans where the collateral is less than the loan value and the borrower cannot or will not repay, so the bank loses the difference. This is what happens when you have a 125% LTV with no money down in a falling market

Initially people thought it was (1) but realised it was (2). At that point the government had already guaranteed deposits anf figured might as well be hung for a sheep as a lamb.

Note the inflationists will persist in calling it a liquidity crisis because that gives them a license to literally print money.

Anonymous said...

Don't forget the role played (or more accurately - not played) by the FSA. And remember this was the flagship policy of none other than Gordon Brown and is the foundation of his claim to be the architect of the UKs "economic success".

Pre 1997, the bank of England would have had a word with the directors of Northern Rock probably in the Spring last year, and told them to pull their horns in. But instead the FSA sat on its hands and did nothing.

Anonymous said...

Why are house prices going up again if there is a crash on?

LONDON (Reuters) - Sellers of residential property in England and Wales hiked their asking prices by an annual 5.8 percent in February, a survey shows...

ukhousingbubble said...


The story refers to asking prices not sales prices; sellers may ask, but they will not receive.

Thanks for the comment....


Anonymous said...

The Beeb had some interesting figures in one of their net pages about Northern Rock:

1 million savers, and 800 000 mortgages. Basically one mortgage for each person saving money. A quick look at what the average person can save against the average loan shows how risky this strategy was.


Towjam said...

Asking prices only show what things are not selling for.

That is until the whole market crashes.
Then asking prices show how low you have to go to attract a buyer.