The Impact of the Global Credit Crisis On Northern Rock of the UK - Case Study Example

The Impact of the Global Credit Crisis on Northern Rock of UK Introduction On Sept. 14, 2007, Euroweek reported that Northern Rock, a major UK mortgage lender, had arranged for the use of the emergency lending facility of the Bank of England (BoE), which the publication called “an extremely rare occurrence” (Dammers, 2007). The BoE agreed, in cooperation with the Financial Services Authority (FSA) and the UK Treasury, to act as lender of last resort to Northern Rock; apparently, the bank’s primary sources of funding in the capital markets have suffered from the tight liquidity squeeze, and private sector banks as well as other lenders are unwilling to extend it sufficient credit. According to Euroweek’s analysis, the market appears to have lost confidence in Northern Rock because it is perceived to be an aggressive mortgage lender, and because of the fact that it relies on the wholesale markets for funding. Thus, with the then current weakness in the liquidity market and the negative perception of the mortgage market (although the UK’s own mortgage market remained stable), Northern Rock suffered largely because of market sentiment. This is bolstered by information from Dealogic databases that Northern Rock had no near term large redemption in the commercial paper or bond markets; it was merely denied credit by other banks at usual prices (Dammers, 2007). Three days after the initial news, the government announced that it will guarantee all Northern Rock savings deposits, in order to calm an increasingly apprehensive banking public. By this time, share prices of other financial institutions, such as Alliance & Leicester, had begun showing signs of panic sell-offs by as much as or more than 30%. The share price drop triggered bank runs, particularly in Northern Rock branches where long queues of depositors took out as much as £2 billion. It appeared that investors were not convinced by government assurances that their deposits are secure so withdrawals are not necessary. By October 12, BoE announced it would extend support to Northern Rock until February 2008 (Euroweek, 2007), although the worsening situation for the industry in general turned out to be more serious than originally thought. By August of the following year, news centered on efforts at restructuring the nationalised bank and concerns over the drain on the taxpayers’ purse by the £26.9 billion loan extended to the bank – which the company has already actually paid down to the government by 35% as of that time. Part of the remainder – about £3 billion – was converted to equity by the government. The political opposition saw this as the government handing out more money to the failing company; analysts, on the other hand, felt this to effect a strengthening of the capital structure of the bank, without the infusion of additional funds. Loan quality deteriorated further, however, with more homeowners and unsecured borrowers sinking into arrears, and many among them defaulting on their loans and suffering the repossession of their homes. Moreover, it appears now that many of the mortgages originated not only by Northern Rock, but also other mortgage lenders, are in retrospect “foolishly risky” (Euroweek, 2008). The matter of Northern Rock’s fall presents insights from which this study attempts to draw generalizations about banking regulations and oversight. Perceptions on Northern Rock Northern Rock was a bank that specialised in mortgages (home loans). It demutualised in 1991 and since then experienced rapid growth. Its retail deposit base was supplemented by securitisation and wholesale funding, such that retail deposit only comprised 25% of its total deposits. The bank originated mortgages aggressively, then distributed them by issuing mortgage-backed securities (MBSs), while short-term funding needs were covered by asset-backed commercial paper (ABCP) (Mullineux, 2008; Banyard, 2008). The bank was unable to roll over its short-term obligations, since at that time during the inception of the credit crunch, banks had begun to be suspicious of mortgages and of each other. This is the complete reversal of previous attitudes towards mortgages, because this form of debt used to be regarded as the most desirable type of debt; traditionally, home owners have a good repayment record, and because the prices of real property and housing had been rising steadily, repossessions usually paid of the amounts in arrears (Banyard, 2008, p. 18). Such complacency on the part of mortgage-lending financial institutions have spawned widespread lending practices such as approving loans six times the salary of the borrower, or extending uncollateralized debt, such as a 125% mortgage, and allowing for self-certification (Banyard, 2008). Under the Basel Capital Accord, such risky lending practices should not have been possible for deposit-taking institutions, as such huge loans would have necessitated large capital reserve requirements which the bank would not have been able to comply with. The reason why mortgage loans had risen to the level that they did was that bankers perceived they had farmed out the risk with the use of a fairly recent invention of J.P. Morgan, called the credit default swap (CDS). Credit Default Swaps Banyard (2008) attributes much of the distortion between credit practices and risk assessment to the working of the CDS. As of the height of the financial crisis, there were estimated to be $62 trillion in CDS in existence; to put this in perspective, the amount of CDS exceeds the entire global economy, valued at $52 million, and is fifty times the size of sub-prime assets created which are supposed to underlie the CDS (Banyard, 2008). The CDS is a form of security created by JP Morgan, with the aim of mitigating their risk when loans are lent out. It involves bringing in a third party who acts as insurer to the risk of default, that is, the CDS buyer is supposed to make good on the loan in case it goes sour. In return, the insurer will receive regular payments from the bank as a sort of “insurance premium” (Philips, 2008). The CDS was designed to transfer the risk attendant to loans by means of securitisation, so that the risk on the loan no longer is carried by the balance sheet. By letting the insurer assume the risk of loss, the bank reasons that it no longer carries the risk, taking the transaction out of the purview of the Basel reserve requirements, and freeing up what should have been the capital held in reserve. The bank is thus able to lend out more loans, making more in interest revenues while not assuming the attendant risk (Philips, 2008). The only problem with this scheme is that there will come a point when loans lent to borrowers with poor credit records will tend to default; the acceleration of such defaults will reach a level when the insurers could no longer make the payments, effectively drying up the liquidity and eroding the wealth by rendering the obligations uncollectible. Such a lever was indeed breached in the US, and like a house of cards the financial system that had built its operations on unsecured, sub-prime credit, and scattered the risk through the deployment of CDSs. There was a failure to realize that the risk does not dissipate, but accumulates, as the insurers are of limited number and of limited resources. Contagion from the subprime mortgage market By 2007, there was evidence of a growing default rate in the US in the sub-prime mortgage market. Sub-prime mortgage involved extension of credit to house purchasers with poor credit histories or credit profiles, and mostly based on self-certified earnings projections. The weaknesses in the US mortgage market sparked a contagion effect in the UK credit market, which called into question the quality of the assets underlying the MBSs and SIVs (securitised investment vehicles) established by most banks to invest in the MBSs that were funded by ABCP. In effect, SIVs were thus borrowing short and lending long term. Arguably, the SIVs were engaging in an intermediation function similar to banking, which accepted short term deposits, thus creating liquidity from which long-term loans are made. SIVs therefore beame “shadow” banks; many of which are themselves managed by banks. Such were regarded as off-balance sheet items, however, and therefore not subjected to the usual on-balance sheet capital requirements (Mullineux, 2008). Effectively, the banks gained exposure to credit and liquidity risks through their SIVs, since the latter had relied on the banks to finance them through the ABCP and to underwrite access to liquidity through the provision of credit lines, which are essentially promises to supply credit should the access to money markets be cut off for any reason. In short, “deposit-taking banks were guaranteeing the liquidity of the ‘shadow’ banks and securities-oriented investment banks” (Mullineux, 2008, p. 8). Even as they acted as guarantors to the secondary banking system, such banks nevertheless maintained that the off-balance sheet SIVs maintained no claim on their capital, which backed only their on-balance sheet activities, the two being separated by a “firewall”. As the rising defaults on sub-prime mortgages gained momentum, reappraisal of their value and attendant risk, there was a simultaneous erosion of confidence in MBSs and similar other asset-backed securities. This set the stage for bank runs, the credit crunch, and a paralysis of the financial markets. The General View Johnson (2008) attributed the fall of Northern Rock to a three-stage process. The first stage saw packaged US mortgages rendered unmarketable, leading to unprecedented write-offs. Defaults led to downgrades, which in turn led to many sellers and no buyers, ending in market closure. The second stage is marked by pass-through mortgages that became unmarketable in the UK due to the financial crisis in the US. The problem per se was not because defaults rose, but because the buyers and ratings agencies expected that they would, and consequently pre-empted each other in taking positions to this effect. What occurred was something in the form of a self-fulfilling prophecy, thus the subsequent occurrence of the negative event anticipated was exacerbated by the collective actions taken. Finally, the third stage was when professional money market operators realised the need for a functioning secondary market for the pass-through mortgage packages. According to Dammers (2007), "What is interesting is that from a Basle II perspective, Northern Rock is a fantastic buy …They have very low cost-income ratios, originate quality assets and this shouldnt have happened. However, by funding so much over one to three month markets, they have come unstuck and a big bulk of rolling paper is due in the coming weeks" (Dammers, 2007). While it is granted that Northern Rock’s portfolio was aggressive and its deposit base and other sources limited, the bank was not alone in this; its actions mirrored an industry that was overly ebullient to the point of recklessly ignoring prudential risk practices. Consolidating Analysis Northern Rock is like any other bank, taking deposits and converting these to loans. However, the Northern Rock model is different, because of two innovations. First, unlike traditional banks that funded themselves the “old-fashioned way”, through the taking of deposits and establishment of branches. Northern Rock, on the other hand, maintained a narrow deposit base. The bank relied for funding more on professional through the money markets. This allowed the bank to get by with a greater flexibility, leaner staff, and lower operating and property costs. The second innovation was expanding its lending beyond the Newcastle locality, to the greater expanse of the UK by offering its loans through a network of agents. After it had originated a certain amount of loans (about £500 million), the bank would securitise the loans and sell them to another professional investor, in the form of mortgage backed securities. The effect is much that which was discussed concerning credit default securities: Northern Rock had been able to issue loans far beyond its capital could prudently support, thus as long as its MBSs could be farmed out at one end, it could continue making mortgages at the other end. Unfortunately, because this technique of passing out the risk out of the balance sheet was intentionally designed to circumvent prudential bank practices, the safety nets and prudential standards set by the Basel Accord, which were meant to protect the public and ensure a healthy financial sector, this same sector lost its fail-safe mechanism that would have alerted the authorities, the investors, and even the management, to the development of a dangerously risky situation before substantial damage had been sustained. Conclusion This investigation had sought to examine the case of Northern Rock’s financial collapse that led to its subsequent nationalisation. It seeks to view these series of events in the context of the financial crisis, and to arrive at generalisations that pertain to both the industry and the bank in particular, with a view to recommending measure to prevent the recurrence of such a phenomenon. Northern Rock operated within a financial environment marred by systemic imperfections. Unbridled optimism led brokers and banks to ignore risks and the signs of impending failure. The creation of exotic derivatives and securities, such as mortgage-backed securities and credit default swaps, and over reliance on them in the management of risk despite a lack of understanding as to their consequences, was instrumental in the breeding of false confidence that unlimited credit can be made without regard to the attendant default and liquidity risks. Furthermore, the absence of a secondary market for such securities robbed the financial community of a reliable means of valuation that would have acted as an early warning system, as well as a mechanism for dissipating risk. Since no secondary market exists for these assets, there was no easy manner of risk management that would have been provided by an exchange where such assets may be unloaded, or which may perform as valuation tool for them. Instead, valuation relied on the assessment of credit rating agencies, many of which admittedly were compromised in their ratings by the fact that the issuers paid for the agencies’ services. Aside from weakness in the financial system’s infrastructure, which is magnified by the contagion spread by a crisis that originated across the borders, Northern Rock’s model is likewise to blame for its problems. Its small deposit base, and reliance on capital markets for funding is a major factor in the recklessness with which the bank embarked on its ventures, as it has little motivation to regard with the necessary diligence its commitments to its depositors. Had it been more mindful that it was risking its depositors’ money, the bank may have proceeded more cautiously. Instead, it had gained for itself an aggressive reputation as a mortgage lender, having captured 18.9% of net mortgage lending in the UK. Thus, when the mortgage market was heavily hit, the market was quick to react in distancing itself from the high risk assumed by Northern Rock. According to Mullineux (2008, p. 11) “The Northern Rock debacle revealed that it is unrealistic to expect uninformed depositors in an increasingly complex financial system to co-insure against the risk of bank failures.” A bank could not mindlessly and indiscriminately continue to assume risk, and expect its depositors and shareholders to insure it against the risk it had intentionally exposed itself to. This is particularly true where contagion can exacerbate a bad situation and make it many times worse. “[T]he news is a clear indicator of how the crisis initiated by credit problems in securities backed by subprime mortgages in the US has become one of liquidity, with banks unwilling or unable to lend to each other even if the assets on their balance sheets are sound” (Dammers, 2007). While the environment was bad for all financial institutions, it was particularly bad for those banks built on shifting sand. Northern Rock is one such bank. References Banyard, P 2008 “Between a rock and a hard place.” Credit Management, Dec 2008, p18-19 Collinson, P 2007 “Government guarantees Northern Rock deposits”, Guardian.co.uk¸17 Sept. 2007 Dammers, C 2007 “Northern Rock cries for help as funding markets ostracise it.” Euroweek, 09527036, 9/14/2007, Issue 1021 Euroweek 2007 “Northern Rock offered life support until February 2008.” Euroweek, 09527036, 10/12/2007, Issue 1025 Euroweek 2008 “Northern Rock--heavy weather, but no shipwreck.” Euroweek, 09527036, 8/8/2008, Issue 1066 Johnson, M 2008 “The Northern Rock example.” Credit Management, May 2008, p18-20 Mullineux, A 2008 “Lessons from Northern Rock and the North Atlantic liquidity squeeze.” Melbourne Review, Vol. 4 Issue 1, p7-12 Philips, M 2008 “The Monster That Ate Wall Street,” Newsweek, 27 September 2008. Ritson, M 2007 Northern Rock has eroded its equity. Marketing (00253650), 9/19/2007, p25 Read More