Why did Northern Rock call in the Bank of England ?
The liquidity crisis at Northern Rock is the first sign of the collapse of credit markets in the UK due to the subprime mortgage sage in the USA. Northern Rock was seriously affected by this as it had financed a period of rapid mortgage advances by borrowing heavily in the wholesale markets, that is from other banks.
The Bank of England, in its role as a lender of last resort, has stepped in and provided a lifeline to the stricken bank. However, the problems are drawing attention to the debt ridden state of the UK economy.
This is a novel role for the Bank of England in contemporary Britain. Many staff will probably not remember the secondary bank crisis of 1973.
Original Story of 10 September 2007
The continued rush of depositors queuing to withdraw money from the stricken Building Society / Bank flies in the face of assurances from the Bank of England, the Financial Services Agency, and the Chancellor of the Exchequer. Savers are protected by the Financial Services Compensation Scheme. Savings up to £2,000 are protected in full, and the next £33,000 up to 95%. Beyond the figure of £35,000, there is no protection. It appears that there are many private investors with funds in excess of this figure.
The confirmation by the Bank of England of support for Northern Rock plc on 12 September 2007 is the first major sign of international fallout from the collapse of the US subprime mortgage lending market, and the arrival of the aftermath in the UK.
The irony of Northern Rock is that it was generally deemed to be a successful company. The share price was £12.58 in February, but by 14 September 2007 it had dropped to £4.33. However, it had been dropping for several weeks as the City abounded with whispers of liquidity problems. This is in line with many leading banks, such as Barclays which fell from £7.46 to £5.80 over the last 3 months.
Northern Rock achieved sales growth by offering 100% mortgages on home valuations, plus an extras 25%. Their projected growth rate was 20% per annum and yet the market was only growing at around 10%. In order to gain this volume of business, they needed very attractive mortgage products and also to adopt a flexible approach to consumers with mixed credit records.
| They were so successful that they gained 22% market share of all new mortgages taken out during the first 6 months of 2007. The growth in the issue of mortgages was primarily funded via the wholesale market, as opposed to deposits by individual savers. It is estimated that some 75% of funds come from this source. The near collapse of interbank lending in August effectively starved Northern Rock of funds and caused a liquidity crisis
Although Northern Rock was not the only financial institution to suffer as a result of the drying up of funds from leading banks, the sheer scale of its dependence on this market inevitably led to problems.
In the wake of the avalanche of adverse publicity, it is unlikely that Northern Rock will continue trading beyond the next few months. The company now has to wait patiently for takeover offers. This may take some time as any potential bidder will wish to postpone any commitment until the current volatility has subsided and a considered assessment of the company made.
However, most potential bidders have privately ruled themselves out of the frame. Lloyds TSB has been the favourite candidate, but banking sources indicated it was unlikely to be interested. HSBC - under fire from institutional shareholder Knight Vinke for failing to capitalise on its emerging-markets interests - is also thought unlikely to bid, despite its relatively small share of the UK mortgage market. Other leading banks, including HBOS, RBS and Barclays, are also seen as unlikely to be interested
In the US, lenders such as New Century Financial Corporation, the second largest subprime lender in California, have gone bankrupt. In the UK, as Northern Rock is classed as a bank, the authorities intervened in order to prevent market panic. There have been persistent rumours that several leading UK banks, including Barclays, have liquidity issues and the Bank of England wished to send a clear signal that no major bank will be allowed to fail.
In comparison to the US subprime scene, Northern Rock appears almost prudent. New Century of California took such a lenient view on customers' poor credit ratings that it allegedly would make advances to a person who came out of bankruptcy on the previous day. Northern Rock, on the other hand, has not been accused of failures of diligence in its lending policies and mortgage risk assessment methods. Northern Rock has not been hit by mortgage defaults, but by a lack of finance which is required to fund its ambitious expansion.
The housing market in the UK is now set to follow the downward trend of the USA. Prices have dropped by more than 10% in some locations such as Stockton, California, where the repossession rate is running at 3.7% of households. Also US households have grown accustomed to shopping around for lower cost mortgage deals and regularly re-mortgaging their homes. This option will not be widely available from now on.
In the short term, it is likely that interest rates in both the UK and USA will ease. This decision will be based on the political expediency of adding funds to the market and thereby assisting cash strapped institutions. Such a move is likely to stabilise the decline in house prices, but not reverse recent losses.
Despite the differences between Northern Rock and the bankrupt US mortgage lenders, the root cause remains the same. This is the persistent growth of consumer debt.
In the UK, the average level of household debt, excluding mortgages, is £8,856. Average household debt is £56,000 if mortgages are included. It should be noted that these are average figures and they include a large number of households who do not have mortgages or credit card balances.
Some 11.8m UK households have mortgages and the average amount outstanding is £96,560. In addition, if non mortgage debt is limited to the households with unsecured loans, mainly credit cards, then the debt figure rises to £20,600. Therefore the average total debt of households with mortgages and credit card loans is a staggering £117,160. The Bank of England has never warned consumers about this unsustainable growth in personal debts.
Although the USA figures are calculated in different ways, average credit card and car loan debt is US$18,700 per household, and mortgage debt is US$74,000.
In both countries, but especially the UK, the increase in consumer debt is based on the expectation of rising house prices, full employment and low interest rates. If any of these conditions change, then the results will be serious if not catastrophic. This is already beginning to happen in the USA, where house prices are falling and there is a significant lay-off of labour.
The growth of the UK economy over the last 20 years, has been driven by the steady increase in house prices and underpinned by North Sea oil. During this time, the manufacture of goods in the UK has continued its secular decline as has the number of British owned firms in both the manufacturing and service sectors.
In both countries, the dampening of inflationary pressures due to cheap imports, is unlikely to continue indefinitely. The process of globalisation is almost complete. Wages and material costs are set to rise in China and other far east manufacturers, and this imported inflation will bring to an end the period of consumer led growth in both the USA and UK. This will inevitably lead to period of re-adjustment, during which time interest rates could well rise to double digits.
In the meantime, the uncertainty surrounding financial institutions will continue to unnerve both the housing and stock markets of the western economies. Investors seeking serious returns need to look further afield, and borrowers need to reconsider their ability to repay loans in the event of a significant rise in interest rates.
The bailout of Northern Rock has placed the Bank of England in treacherous waters, and it will be interesting to how they navigate to calmer waters.
International property will remain a safe and profitable investment, but markets in the UK and USA would appear to have peaked. North Cyprus remains an attractive investment location, due to the ongoing partition of the island which has kept prices low in the North. Prices in the Greek Republic of Cyprus have increased, especially since EU accession in 2004, and are now likely to remain stable or even static for the foreseeable future. The main growth in property values is therefore to be expected in the North.
Copyright - Leslie Hardy, 10 September 2007
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