The language was predictably careful and restrained. Last Wednesday, Mervyn
King, governor of the Bank of England, sent a paper on the recent turmoil in
the financial markets to the Commons Treasury committee. His words were
balanced, his tone was even.
Towards the end of his 10-page sermon, he observed: “Central banks, in their
traditional lender of last resort role, can lend . . . to an individual bank
facing temporary liquidity problems but that is otherwise regarded as
solvent.”
King’s covering letter to Treasury committee chairman John McFall contained a
spook-ily prescient line: “I am conscious that in sending you this
statement I am taking a snap-shot of a fast-moving situation with a
long-exposure camera.”
In fact, although the world didn’t yet know it, the situation was moving very
fast indeed. Within little more than 24 hours, news seeped out that Northern
Rock, for years seen as one of the smartest retail banking operations in
Britain, had been forced to seek support from the Bank.
Funds in the wholesale market – money on which it had relied for its headlong
expansion since converting from a building society to a bank a decade ago –
had dried up. Northern Rock needed help.
On Thursday evening, a meeting was convened at the Bank. It included Sir
Callum McCarthy, chairman of the Financial Services Authority (FSA), King,
Sir John Gieve, one of his deputies, and Paul Tucker, the Bank executive
director responsible for markets.
King already knew that a rescue was imperative. Earlier that day, he had met
McCarthy, who had reassured him Northern Rock met its solvency requirements.
This was a case of a bank that was short of ready cash rather than one that
was going bust. And the two men had held a conference call with the
chancellor, Alistair Darling, who had backed the rescue.
The Thursday evening meeting began farcically. Officials asked participants to
go to a back door of the Bank to avoid photographers. Then they were told to
go to Liverpool Street station, a few minutes’ walk to the northeast. There,
they were collected and taken back to the Bank at Threadneedle Street.
By the time the meeting started, news was filtering out that Northern Rock was
in trouble. A rescue in principle had already been agreed. Working out the
details took hours more. Bleary-eyed officials finally left the Bank at 3am
on Friday morning.
In fact, the Thursday evening meeting rounded off a week’s intensive work,
particularly by the FSA, to check that Northern Rock had a future. FSA
officials had been at Northern Rock’s Newcastle head office going through
its books to establish that the bank was still solvent.
For King, the Northern Rock rescue marked the culmination of his sternest test
since taking over as governor four years ago. He had been due to take a
holiday after the Bank released its quarterly inflation report on August 8.
But that was postponed because of the growing liquidity crisis in the
banking system.
Working closely with Gieve and Tucker, he was “very much in charge” of the
Bank’s response to the crisis, said a colleague. King even kept his
predecessor Lord George informed.
By late on Thursday evening, all and sundry from Northern Rock, the banking
world as a whole and the government were desperately trying to spread the
message that there was no need to panic. People with money at Northern Rock
should not worry, they said. After all, it could borrow as much as it liked
from the Bank of England – albeit at a high interest rate.
Darling said: “The problem here is there is a lot of money in the system but
[banks] are reluctant to lend it to each other at the moment.
“Northern Rock . . . can carry on trading, people can use their accounts in
the normal way, they can carry on making mortgage payments in the usual way,
Northern Rock will be able to carry on its business.” For the FSA, McCarthy
said: “We believe it is solvent, meets all capital requirements and has a
good-quality loan book. We are clear it should continue to be open for
business.”
Adam Applegarth, Northern Rock’s youthful, shaven-headed chief executive, made
the despairing observation that a bank that had the explicit backing of the
Bank of England should be safer than any other.
And Angela Knight, chief executive of the British Bankers’ Association, said
that anybody who was “either a saver with Northern Rock or has a mortgage .
. . can be absolutely confident that they have got their money with, or they
have borrowed from, a very sound financial institution”.
The association huffily added: “Everyone should calm down.”
But by the time Northern Rock opened the doors of its branches on Friday
morning, queues had already formed. People wanted their money back. At one
branch, police had to be called to restore order. The scene resembled
something from a fragile Latin American state. In fact, it was Moor-gate, in
the heart of the City.
NORTHERN ROCK had modest beginnings as a building society. It was formed in
1965 from the merger of the Northern Counties Permanent and Rock building
societies. In 1997, it demutualised. Its explosive growth started two years
later when the bank began to use the capital markets to raise funds. Its
focus on mortgages, limited 76-branch network and pioneering use of
securitisation allowed Northern Rock to become a highly efficient machine.
The bank grew Topsy-like to become a leading player in the mortgage market. By
the first half of this year, Northern Rock accounted for nearly a fifth of
new home loans, becoming the biggest player in the market, leapfrogging
HBOS, parent of Halifax.
Applegarth, a Northern Rock lifer, took over as chief executive seven years
ago – making him at 39 one of the youngest bosses of a FTSE 100 company.
Northern Rock’s low-cost model and ability to punch above its weight won many
admirers in the City. But there were also suggestions that the bank was too
aggressive. It has been lambasted by consumer groups for luring in customers
with market-beating savings rates only to slash them later.
Critics also focused on the bank’s innovative Together mortgage, which
packaged up a mortgage with an unsecured loan, allowing customers to borrow
up to 125% of the value of their home. For some this looked too risky, a
charge that Northern Rock denied, pointing out that its mortgage arrears
were under half the industry average. For years, Northern Rock’s formula –
using the wholesale money markets to give it access to funds it could then
lend – seemed to work. But in June, the bank stunned the City by issuing a
profit warning after it was caught out by faster-than-expected rises in
interest rates. The result was a predicted £180m to £200m dent in earnings.
The setback was unfortunate, but it wasn’t disastrous. It was only in early
August, when the wholesale capital markets dried up, that Northern Rock
found itself in real trouble. It waited in the hope that the market would
become easier after America’s Labor Day holiday on September 3.
“But having got through the first week of September, it was obvious that the
market wasn’t easing up,” said Applegarth this weekend.
The pace and intensity of contact with the FSA and Bank of England was
increased. As rumours went round that Northern Rock needed a saviour, it was
approached by other banks. But Northern Rock, and its advisers at Merrill
Lynch, were told firmly by the Bank of England that it should sort itself
out before considering takeover approaches. The bail-out means Northern
Rock’s name is unlikely to recover, and that its future probably lies in
being taken over. “The stigma is the real penalty,” said one analyst.
Few now believe that Northern Rock has an independent future. Even Applegarth tacitly
conceded that the bank is now a target. He said: “The price fall we have had
certainly adds to the vulnerability.”
Applegarth admits that for the next few months, the bank will struggle to
recruit savers: its biggest problem will be persuading existing depositors
to leave their money in their Northern Rock accounts.
The money being lent by the Bank of England is at a punitive rate – a full one
percentage point above Bank rate. That means Northern Rock’s mortgages will
inevitability become uncompetitive. In short, it will be doing little more
than treading water.
Will other lenders find themselves in the same plight, having to go begging to
the Bank of England for help?
Nobody in the City or White-hall is ruling that out, although experts point
out that Northern Rock was a particular case because of the nature of its
business model, with deposits from savers accounting for only a quarter of
the money it lends out; the remaining three-quar-ters comes from the
financial markets.
Other lenders used the ploy, too: last year an astonishing 50% of the £130
billion in mortgages written were linked to funding in the capital markets.
Building societies rely more on savers’ deposits: indeed, the law says at
least 50% of funds must come from deposits, and in fact, the figure is far
higher.
NORTHERN ROCK’s plight has been excruciatingly public. But it represents only
one manifestation of the banking system’s liquidity crisis.
At the top of the financial tree, investment banks will inevitably suffer.
Nick Hill, analyst at the Standard & Poor’s rating agency, predicts
pretax profits for the second half of this year could fall by 70% as the
banks are hit by potential write-offs on leveraged finance loans and
structured credit products.
And analysis of investment-banking profits by Thomson Financial/Freeman &
Co show just how lucrative the securitisation of loans has been in boosting
banks’ fee income.
The Thomson data suggest that for the year to date, Barclays Capital has made
about £77m in fees on the securitisation of loans in the UK – equivalent to
more than three-quarters of its fee income from the debt capital markets.
For Deutsche Bank, the figure is reckoned to be about £55m. Lehman Brothers is
estimated to have charged £46m in fees – an astonishing 88% of its entire
fee income from debt capital markets.
That income is now fast drying up. Banks will be further hit by sharp falls in
trading of fixed-income products.
They face looming problems with exotic investments such as the $370 billion
(£184 billion) worth of structured investment vehicles and off-balance-sheet
conduits that borrow with a sequence of short-term loans to buy
higher-yielding, longer-term investments.
At the other end of the scale, small businesses are seeing the effects. Simon
Briault of the Federation of Small Businesses said: “We have anecdotal
evidence already that . . . banks are being a bit more cautious about who
they lend to and how much they lend.”
For all banks, not just Northern Rock, caution is indeed the new watchword.
Only a day before the bank’s crisis emerged, the chancellor Alistair Darling
was urging banks to “ask more searching questions . . . Institutions
themselves need to open their own eyes and be more honest. When someone
comes up with a fantastic way of making money they need to ask, how is this
money being made and what are the risks?”
Now, investors – and indeed business as a whole and the Treasury – are asking
how long the money markets will remain in their current sclerotic state.
Sandy Chen, an analyst at Panmure Gordon, predicted last week that the
problems will stretch well into next year.
And in the City, the man facing the most searching questions of all is Adam
Applegarth. Since he took the helm at Northern Rock, he has been the bank’s
sole public face. He was the one who accepted the plaudits when things were
going right. Now, he is the one carrying the can since everything went so
appallingly wrong.
Northern Rock’s entire business strategy was founded on the notion that the
global money markets would always be open to it. No matter how many
mortgages it advanced, more funds would always be there for it to borrow.
As it has now discovered, this was a spectacularly, recklessly overconfident
assumption.
It has cost Applegarth his reputation. It is likely to cost Northern Rock its
independence.
Additional reporting by Louise Armitstead, Ben Laurance, Jenny Davey and
Rachel Bridge
Long history of bailing out City
THE most serious money-market crisis faced by the Bank of England in modern
times was the secondary banking crisis of the early 1970s. So-called
“fringe” banks, struggling to find ways of making money when faced with
competition from the big four – then Barclays, Midland, NatWest and Lloyds –
started lending to the property sector.
As the Bank itself wrote later: “There was a widely held belief that property
was the inflation hedge par excellence, a belief which was adhered to in
some quarters with blind assurance.”
But commercial property was much riskier than it seemed. When business rents
were frozen at the end of 1972, and this coincided with a sharp rise in
interest rates, property prices starting falling and the loans suddenly
started to look sick.
One fringe bank, London and County Securities, which had many individuals
among its depositors, found it could no longer obtain funds from the money
markets. Other fringe or “secondary” banks were in a similar situation.
Depositors took fright, and some of the fringe banks suffered serious runs.
Foreigners, who had relied on the City’s reputation as security, began to
take their cash elsewhere.
So over the Christmas and New Year of 1973-4 the Bank held crisis meetings
with the big banks. The result was a £1.2 billion “lifeboat” – equivalent to
about £10 billion now – to provide liquidity for the secondary banks. Then,
as now, the aim was, as the Bank put it, to “avoid a widening circle of
collapse through the contagion of fear”.
The crisis eventually passed, but it was a bloody one, made worse by the
turbulent economic backdrop.
There have been crises for the Bank since. Britain’s banks faced pressure over
dodgy Latin American loans in the early 1980s. In 1984, the Bank rescued
Johnson Matthey Bankers, buying it for just £1.
Fifteen years ago today, the Bank fought, and lost, when currency speculators
forced sterling out of the European exchange rate mechanism (ERM).
Later in the 1990s, it decided that Barings, one of the City’s most venerable
institutions, could not be saved after trader Nick Leeson gambled and lost
millions. And the Bank had to endure a period of money-market turmoil during
the hedge-fund crisis of autumn 1998. Then, however, the Bank was not
obliged to launch the lifeboats.
IT’S WORSE IN AMERICA
A HOMEOWNER in North Carolina defaults on his mortgage and Britain’s Northern
Rock calls on the Bank of England for emergency funding.
America’s sub-prime mortgage crisis has spread across the world like the
butterfly effect – a branch of chaos theory that argues that the flapping of
a butterfly’s wings can lead to a tornado on the other side of the world.
So far, the biggest losers have been in America. Home foreclosures rose 9% in
July from June and were 93% up on a year earlier, according to RealtyTrac,
an online marketplace for repossessed properties. Some 619,000 people face
repossession. Several dozen American mortgage firms have been closed down in
the past six months – two of them, New Century Finance and American Home
Mortgage Investment, were big players.
The country’s biggest lender, Countrywide, has seen its share price plummet.
Hedge funds have lost billions, and Wall Street banks are still assessing
the costs.
Countrywide said it expected to cut 12,000 jobs, about 20% of its workforce,
in the next three months, and that market turmoil would probably reduce its
lending volume next year by about 25% from this year’s level.
Founded by Angelo Mozilo, the straight-talking son of a Brooklyn butcher,
Countrywide has risen to the top of the American home-loan market since it
began in 1969. In a letter to employees, chief executive Mozilo called the
downturn in the mortgage market “the most severe in the contemporary history
of our industry”. He added: “During the past two years the growth in
home-price appreciation has stopped dead in its tracks and in many areas of
the country it has turned in the wrong direction. There have also been
significant increases in delinquencies and foreclosures among far too many
borrowers.”
Countrywide was a big player in some of the riskiest and most lucrative loans
now causing havoc in America. The firm was a big seller of very low “teaser”
interest-rate loans that would subsequently be switched to higher rates.
Borrowers were encouraged to refinance into another loan to avoid a jump in
payments, generating a new round of fees and profits for Countrywide. The
firm was also the leading promoter of pay-option adjustable-rate mortgages,
loans that give borrowers the option to pay no principal and less than the
full amount of interest normally due, setting them up for much higher
payments later on.
Countrywide’s woes are being felt throughout the American mortgage market. The
firm provides funding for nearly one of every five home loans granted in
America. It has traditionally sold the bulk of those loans to other
investors – something it is finding increasingly hard to do.
Its shares regained some of their losses after the firm obtained $12 billion
(£6 billion) in secured financing, but on Friday they were still down at
$19.39 from a year high of $45.26.
The risks have spread to the credit-card market. Last week Washington Mutual,
one of America’s largest credit-card firms, warned of a rise in bad loans.
The firm said it would set aside as much as $2.2 billion this year to cover
potential loan losses, $500m more than predicted.
