As the queues lengthen outside branches of Northern Rock, populated by depositors acting on the safe side and moving their money, it is gradually becoming clearer how and why this oh-so-modern mortgage lender moved from “Situation Squeeze” to “Crunch Time” in a matter of days.
Rock, we can now state confidently, has been running in ’safe mode’ for at least five weeks. Its statement to the market on August 20 will be seen, with hindsight, as utterly misleading - if perfectly legal:
In response to investor enquiries we are also taking this opportunity to provide an update on Northern Rock’s holding of US Collateralized Debt Obligations (CDOs) and US home equity mortgage backed securities within its Treasury banking book.
Northern Rock’s total investment in these asset classes is minimal, representing 0.24% of reported total assets of £113 billion at 30 June 2007. These investments are intended to be held to their maturity and none have been downgraded or had their outlook changed by any rating agency.
Northern Rock’s investment in US CDOs amounts to approximately £200 million, all of which is investment grade (59% AAA, 28% AA, 8% A and 5% BBB). The Company has no exposure to the equity tranches of any US CDOs. The investment in US home equity mortgage backed securities amounts to approximately £75 million, all of which are rated AAA. These securities have a duration of less than two years and no exposure to 2006 or 2007 lending.
If this bank was American, this would constitute Exhibit X on the desks of so many class action lawyers.
A genuine communication would have said: “While we have minimal direct exposure to US subprime, contamination of the wider credit market has exposed a deep structural flaw in our business model. A buyer is being sought for the bank with some haste. Merrill Lynch is on the case.”
When no buyer could be found, Northern Rock had no option but to go to the Bank of England and seek emergency funds, which it did at the beginning of last week. But as the BBC’s Robert Peston points out on his blog, the Bank’s terms included a harsh clause: it would extend a lifeline to an independent Northern Rock, but it could not be used in anyway to shield investors (rather than depositors) from losses.
What follows from that? Well, the Bank of England would remove the emergency lending facility more-or-less the moment it was taken over by a bigger bank.
If it didn’t do that, the Bank of England could be accused of subsidising the sale of Northern Rock and propping up the value of Northern Rock’s shares and bonds, which is the last thing it wants to do.
But, as Northern Rock found out when looking for a buyer this summer, no bank has the confidence to buy Northern Rock and attempt to refinance its balance sheet on the money markets in the normal way.
Two banks, one being Lloyds TSB, are said to have been ready to take Northern Rock over, but only on the condition that the Bank would keep its financing guarantee in place — which it said it wouldn’t.
Those discussions are assumed to have taken place on Thursday, explaining the acceleration of the crisis that day, which culminated in the Bank’s Council of Directors being called to an emergency session at 9.30 that evening.
Friday was a wipe-out as far as the authorities were concerned. But the weekend provided time for the truth to dawn: in a financial crisis the line between solvency and commercial viability becomes blurred; by avoiding moral hazard in not extending the financing guarantee, the Bank was instead guaranteeing that Northern Rock grew from a potential one-bank-collapse to a systemic threat as public confidence in the banking system collapsed.
By Monday the Bank had hurriedly reversed its ruling on Rock’s independence; any bank ready to help the authorities can now expect the Bank of England to reciprocate. Needs must…
It’s stating the obvious, but this crisis will be studied through textbooks for years to come.
