The Wreck of Northern Rock

A small bank in northeast England built itself into the U.K.'s third-largest lender by using mortgage loans and securities. When the subprime meltdown hit, Northern Rock collapsed.

By Richard Tomlinson and Ben Livesey
Bloomberg Markets May 2008

Downstream from the 80-year-old cast-iron Tyne Bridge, abandoned shipyards on river banks tell the story of a once thriving coal mining and steelmaking center in Newcastle-upon-Tyne in northeast England. Locals pride themselves on their independence from London. Even the way they speak, with a vowel-distorting accent, distinguishes them from the rest of the country. The word our is pronounced wor and town is toon.

It was on the Tyne Bridge that Adam Applegarth and four fellow directors of Northern Rock Plc celebrated the bank's initial public offering on Oct. 1, 1997. During the next 10 years, the bank became the Newcastle area's largest private employer, with a staff of 6,400.

Northern Rock, whose origins go back to the city's prime in the mid-19th century, saw itself as a corporate standard-bearer for the region, says Sir John Riddell, a director from 1990 and chairman from 2000 to '04. The bank chose to focus on making home mortgage loans. It had little income from commercial loans and unsecured lending, credit cards or checking accounts. The board was determined to remain true to the northeast's spirit of self-determination and avoid a takeover by a big-city bank. "We were pestered by smart young men in sharp suits who came up from merchant banks in London and talked in la-di-da voices about how we were too small to survive and too big to escape the attention of bigger predators," Riddell says. "We didn't like those young men."

For almost a decade, Northern Rock prospered. It funded home loans by packaging an increasing amount of its mortgages into securities it sold as bonds. Applegarth, Northern Rock's rising local star, who became chief executive officer in 2001 at the age of 38, more than doubled profit to 394.5 million pounds ($788 million) from '01 to '06 by following that plan. The bank became the third-largest lender in the U.K., with assets of slightly more than £100 billion. Then, last June, the U.S. subprime meltdown hit. The world fell in on Northern Rock. When the global debt market screeched to a halt, Applegarth said he feared Northern Rock would run out of cash because it had just three months of funding reserves for home loans. On Sept. 14, the U.K. government agreed to bail out Northern Rock. The bank's stock market value had fallen 83 percent in three months.

Northern Rock's fatal mistake was that it didn't adequately hedge against the possibility of a steep rise in the cost of borrowing in international credit markets, says Simon Maughan, a London-based analyst at MF Global Securities Ltd. "It was an extraordinary error," he says. "They were running a balance sheet that exposed them massively to sudden sharp moves in short-term interest rates. They were at risk of losing a fortune."

Northern Rock was foolish not to have other sources of cash in place in August, says Tim Sykes, an analyst at Execution Partners Ltd., a securities broker in London. "They should have had other levers to pull," he says. "They really screwed it up." Last October, Applegarth, testifying to U.K. lawmakers investigating Northern Rock's crash, said nobody could have predicted the shutdown of credit availability in August. Sir Derek Wanless, chairman of Northern Rock's risk management committee--which included Applegarth--said the bank's hedging and risk controls were adequate. "There was an unprecedented and unpredictable change in the market," Wanless told Parliament. He didn't reply to requests for comment. Applegarth and Northern Rock spokesman Brian Giles declined to comment on risk management.

The once small regional bank became too ambitious in a rush to embrace Wall Street, says Bryan Sanderson, who was appointed by the board as Northern Rock's chairman on Oct. 19. The lender securitized mortgages from New York to Sydney, as did the biggest financial firms. It set up an offshore trust that used so-called special investment vehicles. "They pushed the model a bit too hard, too aggressively," Sanderson says. "They got out of their comfort zone. It's a big jump from being a local building society to dealing with special investment vehicles in New York."

On Sept. 14, the day the government agreed to lend Northern Rock emergency funding, the firm was hit by the first U.K. bank run since 1866. Customers stampeded Northern Rock branches, as news leaked of a state bailout. "I would have probably done the same thing if I was in their shoes," Applegarth told U.K. lawmakers in October.

Since the run on "Northern Wreck," as the bank is now sarcastically called in Newcastle, the U.K. government has advanced the bank £55 billion in loans and guarantees to keep it afloat. In November, Applegarth, 45, resigned. He stayed until December at the board's request to advise on a new bank strategy. In February, the U.K. government took control of Northern Rock, freezing the share price at the Feb. 15 value of 90 pence.

"Northern Rock has been the messiest banking crisis in the Western world resulting from the global credit crunch," says Vince Cable, a U.K. lawmaker in charge of economic and financial policy for the opposition Liberal Democrat Party.

Northern Rock's collapse has left a trail of casualties. They include Jon Wood, founder of SRM Global Advisers, a Monaco-based hedge fund firm that had built up an 11.5 percent stake in Northern Rock since October 2007. SRM might sue the government because of hedge fund losses following the takeover and freezing of the share price.

Ordinary people are also victims of the Northern Rock collapse. Ivy Ormond, 85, a retired secretary, has had a savings account with the Newcastle lender since 1942. As a depositor, she received 500 shares worth £4.52 each from the mortgage lender's 1997 IPO. In February, when the government took over the bank, Ormond's shares were frozen, like everyone else's, at 90 pence. "The Rock really was our rock," she says.

Applegarth declined to discuss his role. "I've no desire to talk to the press; OK, bye-bye," he said after being contacted via his mobile phone. He lives in a gated two-story gray-brick country mansion called Beechwood House near Newcastle that he and his wife Patricia bought for £1.42 million in 2003 with a mortgage from Northern Rock. Applegarth is one of the few Northern Rock investors who wasn't wiped out when the bank collapsed. He sold £1.6 million of Northern Rock shares on Jan. 26, 2007, at £11.98 per share, the bank's filings show. He still owns 98,000 shares, worth £88,200 at the frozen Feb. 15 price, according to data compiled by Bloomberg.

Applegarth hasn't totally disappeared from view in the region. He's a governor of Newcastle's private fee-paying Royal Grammar School, founded in 1545. And he's a member of his hometown Sunderland Cricket Club, whose facilities manager, John Charlton, is the nephew of Sir Bobby Charlton, the former England soccer star who was born in the northeast.

Applegarth said on a conference call for analysts on Sept. 14 that Northern Rock failed because on Aug. 9 the bank couldn't find anyone, anywhere in the world, who would lend it money. "Life changed on Aug. 9, virtually like snapping a finger," said Applegarth, adding that nobody could have predicted a total shutdown of global credit markets.

"Applegarth was being totally disingenuous," says David Lascelles, senior fellow at the Centre for the Study of Financial Innovation, a research group in London that studies Europe's banking industry. "It's no accident that it was Northern Rock rather than another bank that crashed, because he was running an extreme business model."

The former CEO briefed employees in an internal memo on July 25 about Northern Rock's first-half results. They showed the bank had increased lending by 47.3 percent compared with the same period in 2006. Northern Rock lent a record £10.7 billion in the first six months of 2007. "It is likely to take the outside world a little time to understand our developing strategy, but you can be assured the outlook for Northern Rock remains very positive," Applegarth wrote. On Oct. 16, Applegarth told a different story to the Parliament's Treasury Committee, which was investigating the bank's demise. He said the bank cut back on lending in the first half of 2007. "We started slowing lending down," he testified.

Sanderson, who resigned as Northern Rock chairman on Feb. 22 after the government took over, says Applegarth and his team were reckless. "Something was not right about the culture and the people who handled it," Sanderson says. "They were just not sufficiently risk averse. One's initial impression is it must have been too macho."

Applegarth's miscalculation about the U.S. subprime crisis has hurt U.K. Prime Minister Gordon Brown's reputation for economic competence. Brown, who was finance minister from 1997 to 2007, set up a new method of overseeing banks in 1997, using three different agencies for the job. The central bank sets interest rates, the Financial Services Authority supervises the financial firms and the Treasury, and the finance ministry controls policy. The Bank of England was previously responsible for bank regulation. In 1991, the Bank of England failed to spot the impending collapse of Bank of Credit & Commerce International, incorporated in Luxembourg and based in London.

Brown's tripartite system failed with Northern Rock, U.K. lawmakers who investigated the bank's collapse concluded in a report published in January. Officials from all three bodies acted too slowly and without coordination when Northern Rock started to falter. The Bank of England, the FSA and the Treasury are all reviewing what went wrong.

"Regulators were negligent, and Northern Rock was reckless," says Cable, the U.K. lawmaker.

Northern Rock's aggressive lending and borrowing contrasted with the bank's origins. Two building societies were founded in Newcastle in the mid-19th century to help thrifty locals buy homes. In the U.S., such companies are called savings and loans. The Northern Counties Permanent Benefit Building & Investment Society held its first meeting in 1850, according to Northern Rock's official history, Building the Northern Rock (James & James, 2000).

The local building society officials met in Mr. Wilcke's Temperance Hotel on Newcastle's Pilgrim Street. John Mawson, a pharmacist and ardent teetotaler, was the first chairman of Northern Counties, one of the two building societies that eventually merged to create the modern Northern Rock. The Rock Permanent Benefit Building Society, founded in 1865 in Mr. Bell's hotel on West Clayton Street, was managed in its early years by Robert Dickinson, a Newcastle attorney. In 1965, after years of negotiation, Northern Counties and the Rock merged.

They said at the time that they combined in order to become a national building society with branches across the U.K. Northern Rock moved to its current site in 1968 on former farmland in the Newcastle suburb of Gosforth. The bank then took on a much more aggressive corporate culture, Riddell says. "It was sourly said in the 1980s that Northern Rock took deposits from impoverished northeasterners and then lent the money to avaricious London bankers to buy expensive houses in the affluent southeast," he says. He first joined the board in 1981 and left in 1985 when he became the senior adviser to Prince Charles. He rejoined the bank's board in 1990.

Applegarth joined Northern Rock in 1982 as an executive trainee. He had just graduated from nearby Durham University with a bachelor's degree in economics. He rose fast. By 1990, he was marketing director, and in 1996, he was promoted to the board with responsibility for marketing, loans and information technology. "Adam was seen as a young blood coming up with ambition," says Robert Dickinson, Northern Rock's chairman from 1992 to '99 and a great-grandson of the first manager of the Rock Building Society.

Applegarth was a loner in the office, says Bob Bennett, Northern Rock's finance director from 1993 until his retirement in January 2007. "He didn't have any close friends at Northern Rock," Bennett says. "His friends tended to be people outside work."

In the summer, Applegarth's social life focused on Sunderland Cricket Club, which was sponsored by Northern Rock. A bowler, he captained the club to victory in the North East Premier League regional cricket championship in 2000, when his team included cricket star Cameron Cuffy from St. Vincent in the Caribbean, who played for the West Indies team in international competitions. Applegarth, named the "Player of the Year" in 2000, was possibly good enough to play cricket professionally, says Ronnie Boyd, a coach at the club.

In october 1997, when he stood with fellow board members on the Tyne Bridge, Applegarth's main job was to set interest rates on savings accounts and home loans to maximize the bank's profit, says Leo Finn, Northern Rock's CEO from 1997 to '01.

The directors saw mortgage securitization as a way to keep costs low and help maintain the mortgage lender's rapid growth, annual reports show. In October 1999, Northern Rock made its first securitization of £600 million in mortgage loans, less than 4 percent of the bank's total loan book. Borrowing money on worldwide credit markets was a cheaper way of raising funds for home loans than opening new branches to take in more deposits from savers, Finn says. "We were an early securitizer, and we became very good and very special at it," he says.

Northern Rock parcelled its loans as collateral in a unit called Granite Finance Trustees Ltd., in Jersey, a U.K. offshore tax haven. By registering outside of England, the bank minimized the amount of tax it paid on the home loans held by Granite.

International banks, including Barclays Plc in London, JPMorgan Chase & Co. and Merrill Lynch & Co. in New York and UBS AG in Zurich, underwrote the sale of the bonds.

Profits rose each year as the bank bundled more mortgages into bonds and sold the securities to investors. In 2001, Applegarth beat three internal candidates, including Bennett, and several external applicants to succeed Finn as CEO. "He was exceptionally bright, somewhat arrogant, but that tempered greatly after he became chief executive," says Sir David Chapman, a nonexecutive director of Northern Rock from 1994 to 2004.

Applegarth increased the amount of mortgage securitizations each year. In 2001, Northern Rock securitized 22 percent of its £22.8 billion of mortgage assets. In 2006, the bank securitized 60 percent of its total mortgage assets worth £79 billion. "The appetite for securitization, particularly in the U.S. and Europe, remains huge," Applegarth wrote to shareholders in the bank's 2006 annual report.

Northern Rock restructured Granite in 2005 to make it simpler to turn more of its mortgage assets into bonds and offer investors a wider range of debt ratings. "Granite became a hungry monster," says Peter Hahn, a fellow at the Cass Business School in London and a former managing director at Citigroup Inc. Sandy Chen, an analyst at Panmure Gordon & Co., a brokerage in London, says Applegarth's fast-growth plan depended too much on one asset, home loans, and one source of funding, securitization. "Their business model was far too extreme," says Chen, who had a "sell" rating on the bank from 2005.

Applegarth didn't see it that way, Northern Rock's annual reports show. With growing profit, he and the rest of the board decided in 2001 to extend Northern Rock's headquarters on its Gosforth campus in a way that matched his own and the bank's high ambition. The bank commissioned Red Box Design Group Ltd., a Newcastle-based architectural firm, to build seven beige-brick office buildings.

Six of the buildings are named after a castle in northeast England. One is Alnwick, the home of the Duke of Northumberland. Another is Lindisfarne, a restored 16th-century castle near the Scotland border. Red Box's extension cost £30 million, Northern Rock's accounts show.

"You only have to look at what Applegarth was building to see that he was set on creating a bank of national and probably international significance," says Jim Cousins, a Labour member of Parliament for Newcastle and a member of the committee of lawmakers that investigated Northern Rock's crash.

In 2004, Matt Ridley, a nonexecutive director since 1994, became chairman, succeeding Riddell. Applegarth, the weekend cricketer, and Ridley, an author of science books, were the U.K. banking industry's odd couple. "Matt Ridley's 23 pairs of chromosomes, together with a doctorate in zoology from Oxford University and a career as a journalist, has equipped him to write books about science, economics and the environment," Ridley says on the home page of his personal Web site.

Ridley's grandfather had been chairman of the Rock Building Society from 1946 until his death in 1964. Ridley's father was chairman of Northern Rock Building Society from 1987 to '92. The younger Ridley, 50, a former U.S. editor of The Economist magazine, had no banking experience. What he shared with Applegarth was a desire to keep Northern Rock true to its northeastern roots while competing on level terms with much larger international banks. "Northern Rock is a global company in terms of where it raises funds, a national company in terms of where it lends, but a regional company in terms of where it mainly employs people," Ridley wrote to shareholders in the bank's 2005 annual report. He declined to comment for this article.

In 2005, Applegarth commissioned a 10-story, semicircular office building to complete the expansion, at a cost of about £20 million.

In 2006, Northern Rock raised £17.8 billion from securitized loans. It had £101 billion in total assets at the end of that year.

In the first half of 2007, as the U.S. subprime crisis tightened credit markets worldwide, Applegarth and his team saw no reason to rein back securitization, company filings show. In May 2007, the bank raised £4.6 billion from securitizations.

When the bank's risk committee met at the end of June, it concluded that Northern Rock's funding model, heavily reliant on securitization and short-term borrowing, was still sound, risk management committee chairman Wanless told the Treasury Committee last October. "There was no indication that our paper, which we regarded as high quality, was damaged by what was happening in credit markets," Wanless said. At the time the bank reached that conclusion, New York-based Bear Stearns Cos. had reported that two of its hedge funds had lost more than $1.6 billion because of subprime debt investments.

In July 2007, Applegarth wrote his message for internal circulation to Northern Rock's employees. He told his staff Northern Rock had increased lending in the first half in worsening short-term credit conditions because he was managing the bank for the long term.

By Aug. 9, a Thursday, Applegarth, Ridley and the rest of Northern Rock's board realized the bank was unable to raise any money because of the global credit crisis, says Ian Gibson, a former senior independent director. "We agreed to let it run through until Monday to see whether it was just a flash in the pan," he says. It wasn't, the bank realized. "Then we contacted the regulator," Gibson says.

The U.K. appointed Ron Sandler as Northern Rock's executive chairman. From 1995 to '99, Sandler, 55, was CEO of Lloyd's of London, the world's biggest insurance market, which came close to collapsing in the early '90s. Now, Sandler has to find some value in Northern Rock, and he must convince European Union regulators that the state bailout doesn't give the mortgage lender an unfair advantage over its competitors.

Sandler says he'll shrink Northern Rock. "This bank will not write as many mortgages at it has done," he says.

Sandler won't be dismantling another part of Applegarth's legacy. Northern Rock's former CEO left behind a work in progress when he drove from the front entrance of Northern Rock for the final time in December. The half-built 10-story tower looms above Gosforth. It will be completed later this year. It's cheaper to finish the project rather than abort it because of penalty clauses in the construction contract.

It stands as a monument to a failed bank, just as the abandoned shipyards along the Tyne River are a reminder of the collapse of Newcastle's past industrial might.

Richard Tomlinson is a senior writer at Bloomberg News in London. rtomlinson1@bloomberg.net

Ben Livesey covers banks and insurers in London. blivesey@bloomberg.net

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