Crisis at Northern Rock

The British mortgage giant is getting a bailout from the Bank of Englandraising questions about banks' vitality in Britain and across Europe

Just how serious the credit squeeze is becoming, not only in the U.S. but also in Europe, hit home late on Sept. 13 when news emerged that Northern Rock (NRK.L), one of the five largest British mortgage lenders, had been forced into a bailout from the Bank of England. In a conference call Sept. 14, Adam Applegarth, Northern Rock's chief executive, said: "Frankly, life changed on Aug. 9, virtually like snapping a finger. Watching liquidity disappear on a global basis has been astonishing."

Northern Rock, a former Newcastle building society taken public in 1997, thrived on—and then was brought down by—its innovative business model. With a relatively small deposit base, it used securitization of mortgages and other capital-markets funding to grow rapidly to a nearly 19% share of the British mortgage market by the first half of 2007.

But a few weeks ago, Northern Rock suddenly found that its various funding strategies were all shutting down simultaneously. In a crisis of confidence, the business model that had looked so good turned out to be no model at all. When the credit freeze failed to thaw in early September, "it was the entirely logical thing to do to approach the Bank of England," Applegarth said.

Customers worried about losing their savings besieged Northern Rock branches, ignoring reassurances from top politicians. By early Sept. 15, Northern Rock was reported to have paid out about $2 billion. It seems unlikely that Northern Rock would go bust with the Bank of England behind it, but the spectacle of something close to a run on a bank can only damage confidence in the previously solid British economy.

An Alarming Development

The bailout, which rocked Britain's financial markets, was an ominous sign, both for other banks and for the broader economy (, 9/6/07). "I think it is an alarming development—this is not a small niche institution," said Simon Adamson, London-based senior analyst at Credit Sights, an independent credit research firm. "It shows the liquidity freeze we are seeing is getting worse."

There are, however, some signs of a slight easing in the credit squeeze as the big central banks pump money into the system. For instance, on Sept. 14 the key three-month Sterling LIBOR rate for banks lending among themselves dropped to 6.82%, from 6.88% on the previous day, down further from the record high of 6.90% touched on Sept. 11, according to the British Bankers Assn. The LIBOR's recent rise has prompted worries (, 9/5/07) about credit.

Still, Adamson and other analysts say that the Northern Rock debacle raises questions about the health of other banks in both Britain and Europe. Adamson notes that of the British mortgage lenders, Northern Rock is the most dependent on the capital markets. It has obtained 77% of the financing for its $230 billion in assets from covered bonds and other securities, vs. just 23% from its relatively small $46 billion deposit base.

By contrast, Bradford & Bingley (BB.L), another lender seen as facing pressure, obtains just 58% of its financing from the capital markets, Adamson says in a recent report. "Nonetheless, we think it is quite possible that liquidity support will be needed by other banks," he notes. "In general, any midsize bank that relies predominantly on wholesale funding could be vulnerable."

Time to Stem Growth

The Northern Rock bailout also raises questions about the future growth of the British economy, Europe's strongest in recent years. Applegarth said that Northern Rock, which churned out close to $40 billion in lending in the first half of 2007, was now sharply tightening up; one analyst estimates it would now fund just 2% of the new mortgage market, down sharply from its previous 19% share. "The banks are shutting the doors to new lending and that's going to stem growth," says Justin Bates, an analyst at investment bank Daniel Stewart & Co. (DAN.L) in Manchester.

While the problems of a mortgage lender such as Northern Rock also could present opportunities for other banks to increase their market share, the worry is that instead there will be a general pullback in mortgage issuance, which has been red hot for the past several years. In addition, those banks that are lending are edging up their interest rates, putting pressure on borrowers. All of this is likely to have a negative impact on British real estate prices, which have soared in recent years (, 5/16/06), fueling economic growth. (There's also worry about a broader slowdown in real estate (, 8/31/07) across Europe.)

The Bank of England will lend an unspecified amount of money to Northern Rock against "appropriate collateral," which in this case will be Northern Rock's portfolio of mortgages. Applegarth said that the Bank of England will charge "a penal rate." He was unwilling to specify the amount Northern Rock would draw, except to say that it was "large."

Excessive Risk-Taking

Curiously, Bank of England Governor Mervyn King only two days before had warned in a letter to the Treasury Committee of the House of Commons about the drawbacks of pumping money into the banking system. "The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behaviour," King wrote. "That encourages excessive risk-taking and sows the seeds of a future financial crisis."

In the case of Northern Rock, the Bank says it is lending to an institution facing temporary liquidity problems because "the failure of such a bank would lead to serious economic damage." The danger of encouraging "moral hazard," or excessive risk-taking, is mitigated by the provision of a penalty rate, the bank says. A spokesman noted that the Bank of England is ready to be a lender of last resort "for banks facing a temporary problem." Still, though there is no danger of depositors losing their money, worried customers lined up outside Northern Rock branches around London.

Northern Rock warned that its profits for 2007 would be between $1 billion and $1.09 billion, excluding possible loss provisions or gains, well below its $1.18 billion earnings in 2006. But earnings are irrelevant at this stage. The bank is a distressed asset with its continued independence very much in question. Potential buyers will try to figure out what its loan book and other assets are worth. On Sept. 14, the bank's stock, which was already down about 50% on the year, fell another 32% to about £4.37 ($8.79).

The news hit the London markets hard, knocking sterling to a 14-month low against the euro and sending the FTSE 100 index to a loss of 0.9%. Bank stocks, including such lenders as Bradford & Bingley, Alliance & Leicester (AL.L), Paragon (PAG.L), and the much larger HBOS (HBOS.L) all got smacked.

The Next Year Tough to Predict

One irony in all of this is that Northern Rock was not apparently a reckless lender. Arrears on its mortgage portfolio are just 0.47%, about half of the average for British institutions. What got the bank in trouble were the same innovative financial techniques that spurred its early growth. It even executed this strategy fairly well, analysts say. Credit Sights says the bank's funding was "well diversified by maturity and type, and this should have operated well in most circumstances, apart from the unlikely event that the wholesale markets shut down across all products." Which is, of course, what happened.

One questionable practice was the bank's investing in about $1.2 billion in various exotic financial instruments including Structured Investment Vehicles (SIVs), which are generally used to make a profit by arbitraging the yield difference between long-dated and short-dated securities. These exposed it to about $150 million in U.S. subprime loans and $400 million in U.S. collateralized debt obligations, or CDOs. But those investments, while unwise, don't seem to have been the major cause of Northern Rock's problems.

In his call, Applegarth sounded humbled by what he had been through. "It is very difficult to see how 2008 is going to look," he said. But business seems certain to be tougher. "I would imagine lower growth, wider credit margins, and [being] more selective on customers," he said.

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