Friday, September 14, 2007

(Northern) Rock - Paper (Tiger)

On 12 September 2007 (in a Paper submitted to the Treasury Committee by Mervyn King, Governor of the Bank of England) the Bank told the world the following:

“…the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept”.

On September 13, 2007, we received the announcement that the Bank of England, as part of a joint action by HM Treasury, the Bank of England and the Financial Services Authority (according to the Memorandum of Understanding between these three parties), had bailed out Northern Rock, a specialist mortgage lender, by providing it with a short-term credit line. Without this, Northern Rock, which funds itself mainly in the wholesale markets, would not have been able to meet its financial obligations.

It will be interesting to see how this reported credit line is secured, or how any draw-downs of this credit line are collateralised. If Northern Rock had sufficient collateral eligible for rediscounting at the Bank of England’s Standing (collateralised) Lending Facility, it presumably would have done so, rather than invoking this emergency procedure involving the Bank, the FSA and the Treasury. Collateral eligible for rediscounting at the Standing Lending Facility consists of sterling and euro-denominated instruments issued by UK and other European Economic Area central governments, central banks and major international institutions rated at least Aa3 (and, exceptionally, US Treasury bonds). Such assets are said to be scarce on the balance sheet of Northern Rock. The severity of the penalty rate (relative to the policy rate of 5.75%) charged Northern Rock will also be important in determining the long-term damage to financial stability caused by this operation.

The Bank’s September 12 Paper recognises conditions when this kind of bail out is justified:

“…, central banks, in their traditional lender of last resort (LOLR) role, can lend “Against good collateral at a penalty rate” to any individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility”.

The MOU states in paragraph 14:

14. In exceptional circumstances, there may be a need for an operation which goes beyond the Bank’s published framework for operations in the money market. Such a support operation 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 to the UK economy.”

It is clear that the conditions for a justifiable bail out, as specified in the MOU and reiterated in the Bank’s September 12 Paper, were not satisfied.

First, it is by no means obvious that Northern Rock (total assets £113 bn as of 30 June 2007) suffered just from illiquidity rather than from the threat of insolvency. The organisation has followed an extremely aggressive and high-risk strategy of expansion and increasing market share, funding itself in the expensive wholesale markets for 75% of its total funding needs, and making mortgage loans at low and ultra-competitive effective rates of interest. No matter how efficient you are, or how safe your assets are, if the effective interest rate on your borrowing exceeds that on your investments, you are unlikely to be a long-term viable proposition, no matter how impressive the growth of your turnover. Northern Rock’s share price had been in steep decline since February of this year, well before the financial market turmoil hit.

Second, it is hard to argue that the survival of Northern Rock is necessary to avoid a genuine threat to the stability of the UK financial system, or to avoid a serious disturbance to the economy. The bank is not ‘too large to fail’. As the fifth largest mortgage lender in the UK, it is not systemically significant. When all else fails, the ‘threat of contagion’ argument can be invoked to justify bailing out even intrinsically rather small fish, but irrational contagion, that is, contagion not justified by objective balance sheet and off-balance sheet realities, is extremely rare in practice, and could have been addressed directly had it, against the odds, occurred, following the insolvency of some bank.

No doubt its depositors (of which there are rather too few) are covered by the Financial Services Compensation Scheme to the tune of £31,700 per person (100% of the first £2,000 and 90% of the next £33,000). If most of its mortgage assets are good (albeit unprofitable, given Northern Rock’s funding costs), they will find willing buyers among the remaining viable mortgage lenders. Northern Rock’s shareholders would, of course, lose everything and the remaining creditors (including depositors with balances in excess of the deposit insurance limit) would have to wait to see how much the realisation of the assets generates. Top management would lose its jobs. All this is as it should be. What would happen to staff below the strategic decision-making levels would depend on which parts of the business remain viable after the financial restructuring following the insolvency.

Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let’s hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.


Laban said...

Willem - this is fascinating stuff and thank you for it, but can you explain NRs business model a bit more - I can't work out why simply stopping new lending should break them, unless the money they've already borrowed (i.e the existing mortgage book) is short term and they need to borrow to repay those short term loans.

I gather they can't continue to lend money unless they borrow it, because they haven't got a big enough base of depositors. The Bank of England are lending at "a punitive rate of 6.75%". But the 3-month inter-bank lending rate (LIBOR) is only 0.13% higher at 6.88% - why can't they borrow there ?

Ah - LIBOR reflects short-term loans - up to a year. Presumably NR want long-term money - or do they live hand to mouth, so to speak, on a succession of short term loans ? Seems like a risky strategy to me. How is the money that've already borrowed (and lent out) financed - short or long term loans ?

You have to presume that it's not the interest rates so much as that the other banks are REFUSING to lend to NR.

If that's true, what do the other banks know that the Bank of England is prepared to ignore ?

If they can't borrow the money at a rate which will enable them to offer attractive mortgages, why don't they just stop new lending ? Presumably the answer is that they'd be basically shutting up shop to new business, with no future NB-generated profits to look forward to and a huge share price fall. But why should the BoE be concerned with that ?

david said...

I couldn't agree more with what you write re moral hazard.

As an investor I have avoided much of the financial and housing sector because I believed we were in a giant leveraged financial bubble and eventually the chickens would come home to roost.

Having missed out on some substantial gains by adopting that prudent approach I now find that the equity markets which I am short of, are being supported by the actions of the central banks and now the Bank of England has stepped in to save, as you said an organisation which was clearly following a high risk strategy.

First we had the Greenspan Put now we have the B of E Put.

As I now see it,and I believe other previously cautious investors will reach the same conclusion, there is no sense in considering company risk when looking at the largest companies,particularly the banks, in the financial sector. Too big to fail and as leveraged as possible is what one should look for ie geared up into maximum profit on the way up but little or no risk of failure should the worst eventually happen.

What a message the Bank of England have sent out - Mr King I can't tell you how disappointed I am with you. The Investment banks must be rubbing their hands with glee

Anonymous said...

the problem facing the UK central bank is the same one facing all of them and especially those in the west and their host governments.

they have collectively reached a crossroads of credibility.

expressed best in 1758 by david hume....

"Nothing appears more surprising to those who consider human affairs with a philosophical eye than the easiness with which the many are governed by the few, and the implicit submission with which men resign their own sentiments and passions to those of their rulers. When we inquire by what means this wonder is effected, we shall find that, as force is always on the side of the governed, the governors have nothing to support them but opinion. It is, therefore, on opinion only that government is founded, and this maxim extends to the most despotic and most military governments as well as to the most free and most popular."
David Hume, 1758, "Of the First Principles of Government"

the world since the active usurpation of information by the internet has become a bifurcated place, inhabited by 2 sorts of people. those who interactively go looking for what it is they want in the way of data and those who remain passive, preferring to have a deeply censored meal fed to them.

as the internet seeps further into mass use it dissolves the glue that has held together the nation state which itself has been concocted and held together through the control of opinion.

the internet is one large truth searching machine chewing through every scrap of data separating as it goes, the real from the fairy tale. anyone with a desire to find out what is what and who is really who can do so at little or no cost. this forces all governments and central banks to forsake widespread fraud, lies and deceit in the creation of their policies. a reality regrettably they have not yet figured out.

washington, greenspan and wall street are emblematic of this principle. they all wove and spun gigantic lies and frauds which have either collapsed or in the process are collapsing. washington with its lie based middle east pageant, greenspan whispering into the ears of homeowners to use their abodes as an atm machine and wall street for knowingly creating fraudulent derivatives and the flogging them to anyone and everyone while eschewing the risk.

now we have reached a david hume moment of credibility. washington, greenspan and wall street have lost it and the rest of us will have to suffer the consequences for years and years to come.

none of the central banks have the slightest clue how to solve the multi TRILLION dollar derivative crisis. not one of their tools will fix the problem only make it massively worse once applied, and increasing numbers of awake individuals no longer trust them to try.

welcome to the new world disorder.

Anonymous said...

Fail to see how they can continue to pay out 108m in dividends and claim to be potentially causing economic damage to the system or their customers.

Anonymous said...

Laban - this basically comes down to NRK being unable to roll their commercial paper. By that I mean, they have borrowed using commercial paper which is now coming due. They are seeking to issue new commercial paper in order to borrow and thus repay the creditors of the old commercial paper. That probably came due on Monday, and it takes 2 days to settle so they had to sell it yesterday (Thursday). They failed to sell it and have to go to the BoE instead.

Interestingly, this is exactly the same thing that caused Enron to finally succumb to failure (they were unable to roll their CP too). The only difference is they didn't get a bail-out.

Richard said...

Another question. What's confusing me is the FSA's statement that Northern Rock is solvent. If it's solvent, why does it need the Bank of England's credit? And if it's solvent because of the Bank of England, then that's not really solvent at all is it?

Anonymous said...

Governor King rehearsed the conflict between 'moral hazard' and wider economic damage in his letter to the Treasury Select Committee on 12th September. "There must be strong grounds for believing that the absence of ex ante insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future."

Yes, Northern Rock is small, but the risk of contagion is high. Knowing that governor King and the Bank take their mandate seriously, I interpret their action as an attempt to avoid an avalanche of claims from other troubled lenders. Their action may, or may not be successful, but they have little option if they genuinely believe the economic well-being of the country is at stake. Northern Rock is now irrelevant. What is important is what this action says about the health of the UK financial system as a whole.

Ken Houghton said...

6.75% overnight against a 3-month fixed term loan 1/8th of a % higher is not a bargain by any stretch. As noted above, it's 100 bp (1.00%) over the Bank's o/n rate.

Looks more like a "stop what you're doing and make your business model make sense going forward" than a bail-out, with a 17%+ premium for the time to try to secure/sell off those recent loans.

The question right now isn't "how is it secured?" it's "how SHORT-term is it?" If we're talking "you have a week, two at the very outside, to sell those loans for what they are worth" then it's probably worth charging a decent premium and no having to take the loans themselves on.

If it's longer than that, then the bank will go under, and we'll get a more orderly retreat than today's pictures indicate, with a few more pence to offset the pounds of lose that will make the combined dieting of Oprah, Valerie Bertinelli, and Kirstie Alley look as if they were attendees at the feast of the Ghost of Christmas Present.

Anonymous said...

Mr King's statements and follow-up activities bring to mind our own Mr. Poole of the Dallas Fed.

Ocham said...

>>What's confusing me is the FSA's statement that Northern Rock is solvent.

Solvency usually means the ability to make payments when they are due. Under that definition NRK are clearly solvent, as they will make a net profit this year (although the target has revised downwards).

The ability to meet payments indefinitely far into the future is a different matter. No institution of this kind can continue funding at the penal BoE rate indefinitely.

The company's interim results are here

Anonymous said...

Willem, you are a far more intelligent person than me, but I simply must take issue with your "let NR fail" argument.

In the current market situation, letting NR fail would, without stretching, have had catastrophic knock on effects.

First the markets would have asked "Who's next?": Alliance & Leicester, and B&B both rely signficantly on securitization to fund mortgages (wholesale and retail customers would have withdrawn what funds they could), next every single UK bank would have seen a substantial increase in risk premiums as central bank liquidity support became less certain, UK banks would have further hoarded liquidity and NR's secured bonds (50-75bn?) would become illiquid and impossible to value, further exacerbating the crisis in the sterling wholesale markets, UK mortgage rates would rise as banks were restricted in their access to capital and became more reluctant to take liquidity risk and lend long, etc.

None of this refutes your moral hazard argument, but I think one could be certain every central bank in the world would have acted the same way, and those are some of the reasons for it.

Make no mistake, this is virtually equivalent to an orderly bankruptcy that will achieve the ends you desire, the shareholders and the management team lose a lot of money and that is the way it should be, but by providing liquidity, the senior creditors should have confidence that their money is safe, the alternative is almost certainly too catastrophic, with nothing really to be gained, given NR as an independent institution is toast.

DorsetDipper said...

“depositors with balances in excess of the deposit insurance limit … would have to wait to see how much the realisation of the assets generates … All this is as it should be”

Oh no it isn’t. Prof, you must be nuts if you think this is a satisfactory outcome of this episode.

Cassandra said...

Monjo said...

The US bailed out Citigroup (and probably BoA) before. They are now the 2 largest banks in the world.

The wider implication of a NR collapse would hit hard. NR has funded itself through loans from other banks. If NR can not make these payments to the other banks then their liquidity will be threatened too. This sort of payback must be in the £billions a year category.