Why Northern Rock Crumbled
Scary lesson of the week: No corner of the global financial system is immune to the turbulence in the markets. Until last week, Northern Rock plc (NRK.L) was the pride of Britain's reviving northeast region and a fast-growing star in the English business firmament. The Newcastle-based mortgage specialist had grown rapidly under its brash chief executive, 45-year-old Adam J. Applegarth. By mid-2007 it had become Britain's fifth-largest housing lender, making nearly 19% of new loans. At its peak in February, the bank's market capitalization exceeded $10 billion. "It was best in class," says Gordon Scott, an analyst with Fitch Ratings in London.
Then the good times for Northern Rock and its investors crashed to a halt. On Sept. 13 word leaked out that the bank, squeezed by the credit crunch that followed the subprime-lending crisis in the U.S., had asked the Bank of England for an emergency bailout. The news set off a 1920s-style bank run by depositors, who lined up around the block in front of its 75 branches, ultimately pulling out $4 billion by some estimates. That, in turn, sent Northern's shares into a tailspin; they dropped by 60% in two days. Unless the markets turn around quickly, the bank is likely to be sold to a bigger player. Investment bank Merrill Lynch (MER) is advising Northern on just such an eventuality.
With the government's Sept. 13 decision to intervene, Northern's meltdown doesn't appear likely to spread, at least for now. Yet in the blink of an eye, investors and potential lenders soured on what had previously been the key to the bank's success: an innovative funding strategy to fuel growth. Northern got more than three quarters of the money it loaned to home buyers from international markets, selling mortgage-backed securities and other financial instruments. Suddenly, no bank or investor wanted any of this stuff. "Frankly, life changed on Aug. 9, virtually like snapping your fingers," Applegarth said on a Sept. 14 call to investors.
The bank realized it was in deep trouble in early September when it tried to raise several billion dollars with a new mortgage securitization but found few takers. While not in danger of immediately going under, it would have had to issue a profit warning quickly. It looked for help, and even sought out a buyer for the entire operation.
Northern Rock approached the Bank of England early in the week of Sept. 10. Lloyds TSB (LLOY), a major British bank, was interested in buying Northern, though no firm price was agreed upon. But Lloyds wanted the Bank of England to provide guarantees in the event of a meltdown at Northern, something the central bank declined to do, fearing that the European Union might consider that an unauthorized subsidy, industry insiders say. And Northern Rock also couldn't get its hands on funds that the BOE routinely makes available to banks that find themselves caught short. At the time, central bank rules barred it from accepting mortgages as collateral, even though Northern's loan book was of far better quality than the British average. The BOE relaxed those rules on Sept. 19, but it was too late for Northern. "If they had been able [to get access to those funds], they would have had a lot more flexibility," says Richard Barnes, an analyst at rating agency Standard & Poor's in London.
Eventually the government agreed to guarantee deposits, but that hasn't completely calmed jittery depositors. On Sept. 18 worried customers still lined up outside a central London branch of the troubled mortgage lender, waiting to withdraw their money. Attorney Rachael Whalley, for instance, said she planned to take out her entire $18,000 from an institution she considered "tainted."
Now the risk is that the damage could creep though the economy. Like the U.S., Britain has seen a residential real estate boom that has played a big role in bolstering consumer confidence. But housing prices are showing signs of leveling off. If banks stop lending, economic growth could grind to a halt.
Britain's credit jitters are putting pressure on Mervyn King, the hawkish Bank of England Governor who has received much of the credit for the country's recent stellar economic performance. Unlike his counterparts at the U.S. Federal Reserve and the European Central Bank, King initially resisted helping out the banking system because he worried it would reward excessive risk-taking.
It is likely that the threat of a broader financial crisis, coupled with pressure from the government, forced King's abrupt turnaround. On Sept. 18 the BOE made nearly $9 billion available to the markets in an effort to bring overnight rates, which had spiked to almost 6.47%, closer to the bank's 5.75% benchmark. By Sept. 19 they had fallen to 5.89% as the BOE promised a further $20 billion. And just about every economist is betting that King, who has pushed through three rate increases this year, will now have to begin easing. "We do expect the Bank of England to cut its rates in the next few months," says David Miles, Morgan Stanley's (MS) top economist in London. But for Northern Rock, the damage is already done.