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Northern Rock’s Consequences

The crisis which has engulfed Northern Rock, Britain’s fifth largest mortgage provider, is a real shock to the system for those industry watchers who thought that the credit squeeze wouldn’t impact ordinary people.

More and more this crisis, with its roots in the sub-prime mortgage market in the US, is affecting people’s lives, not just in the US, but in the UK, and probably all over the world.

Last week Northern Rock turned to the Bank of England (BoE) as ‘lender of last resort’ and the BoE agreed to help, in an unprecedented move. Northern Rock had been unable to fund its mortgage customers from the wholesale markets. Its move to the BoE rocked financial centres around the world, caused its shares to take a nosedive, and shattered consumer confidence as customers literally queued around the block, waiting to take their savings out of the struggling bank. Northern Rock (NR) finally turned to the BoE after a week of crisis talks between NR, the BoE, the Financial Services Authority and the Treasury.

The BoE says that such an agreement for support 'is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy'. BoE Governor Mervyn King had previously made it clear that such a helping hand would only be provided in exceptional circumstances and as a remedy for a short-term problem. The BoE obviously believes that market circumstances are extreme enough to give it cause to help Northern Rock. In addition, the fall out for the government and the BoE itself as a result of a failing bank would be intolerable.

Questions may now be asked whether the BoE should have been more forthcoming sooner and considered cheaper loans to financial institutions struggling in the current climate. Similar measures were taken by the US Federal Reserve and the European Central Bank.

Northern Rock says it has been a victim of the lack of credit now available in the markets, but critics say it has been a lender with a flawed long-term business model as it relies on wholesale funding for three-quarters of its loans. Before ultimately going to the BoE, NR would have approached various high street lenders to see if they would willing to assist, and even take it over. As many banks will be watching nervously for their own problems and exposure to sub-prime problems, they would have been unlikely to take on Northern Rock’s already manifest problems.

Although NR has asked the BoE for support in the future, it has probably not yet reached the stage of actually borrowing money yet. It is planning for the future. AT the end of this month NR will probably have to roll over £5bn of debt borrowed from the financial markets, but in the current climate, no one would agree to finance the debt. NR’s balance sheet consists of £113bn of loans and other assets. It has taken an aggressive approach to growing its market share in the past year or so, and took 19% of all new mortgage loans, taking first place off Halifax. In relative terms, however, NR has less savers, so it needs to look elsewhere to fund its borrowers.

Things look even worse now, as savers have rushed to Northern Rock’s doors to withdraw their savings. NR’s share prices has fallen this year, and plummeted in the last few days.

The Financial Services Compensation Scheme covers savings, protecting 100% of the first £2,000 in any bank account and 90% of the next £33,000 - giving a maximum payout of £31,700 if a bank did go bust. However, Chancellor Alistair Darling has said that NR savers would not lose a penny, regardless of how much they had deposited.

Although most other big banks in the UK may not have the same problems as NR because of their major high street presence and broader spread of businesses, they will nevertheless all be affected by a drop in confidence. We will all suffer as the values of our pensions, investments and our own homes fall, and mortgage rates go up again.

Tom Smith
25th September 2007

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