Jeremy Warner's Outlook: Northern crisis rocks financial system

Bank attacked over Rock rescue; Housing correction looks inevitable
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The Independent Online

Little more than six months ago, shares in Northern Rock were trading at an all-time high and the chief executive of Britain's fourth largest mortgage lender, Adam Applegarth, was feted by analysts as the banking sector's pin-up boy. Today, Mr Applegarth's reputation lies in tatters and the Northern Rock brand is very likely toast.

It is hard to recall a swifter or more dramatic fall from grace. Only a small provincial building society when it demutualised 10 years ago, Northern Rock has since grown its share of the UK mortgage market from 3 to nearly 10 per cent, as well as assumed a prominent position in the FTSE 100 index of Britain's leading companies.

Only last June, when I lunched with Mr Applegarth, he boasted of the lowest cost-to-income ratio in the banking sector, and a business model that both made Northern Rock the provider of choice for remortgaging households and enabled him to shower his shareholders with capital repayments and higher dividends. Yet the business model that made Northern Rock so attractive to investors has now proved Mr Applegarth's undoing. Unlike most other substantial mortgage banks, which rely heavily on retail deposits, Northern Rock finances its book largely from wholesale money markets.

This means that it doesn't have to maintain the extensive and costly branch networks of others, but it has also made the bank vulnerable to the seizing up of credit markets we've seen over the past two months. For the time being, Northern Rock is unable to borrow from the markets to finance its business.

Even so, to be forced to go cap-in-hand to the Bank of England for a bail-out is a damning indictment of management, which, despite the warning signs from America of a deteriorating housing and credit market, has been engaged in what with the benefit of hindsight was a completely reckless dash for growth.

In the past year, Northern Rock has shot to the top of the league table of mortgage providers in terms of the proportion of the "new" mortgage market it has won. Nearly one in every five mortgages sold in Britain over the last year has been with Northern Rock. Stellar growth of this sort usually comes at a price, and so it has proved.

Unsurprisingly, Mr Applegarth was trying to make light of his predicament yesterday by portraying Northern Rock as a hapless victim of events beyond its control. Three Spanish banks had availed themselves of a similar facility with the European Central Bank over the past week, he said, and nobody had batted an eyelid. His difficulty, he insisted, was a temporary problem of liquidity. There was no question of Northern Rock going bust.

Well, yes and no. No bank would seek finance from the lender of last resort except in circumstances where it would be unable to honour its obligations if it didn't. This may not technically be insolvency, but it is not that far off.

Everyone was being ultra-responsible yesterday by insisting that depositors had nothing to worry about; their money was quite safe. Yet you can hardly blame savers for queuing down the street to get their money out. Better safe than sorry.

No market professional would lend to a bank that had just been forced to seek emergency funding from the Bank of England except at a whacking great premium to what's normally on offer. Northern Rock's savings rates are not notably the best on the block. Nor are they as good as what the Bank of England is getting for its emergency facility. The Bank's money is also backed directly by collateral. Theirs is not.

Even by Mr Applegarth's own admission, the business model is going to have to change dramatically, with a much heavier reliance on retail deposits to fund the book. That's going to mean a steep rise in costs. Northern Rock's substantial and by most accounts high-quality mortgage book is plainly worth something to someone, but it is questionable whether the rest of the brand has any value left in it at all.

In any case, potential bidders – if indeed there are any, given the present credit turmoil and the fact that the most likely, HSBC, is under siege from activist investors – are going to drive as hard a bargain as possible. The Bank of England rescue presumably underwrites depositors and other creditors. The same may not be true of shareholders. Once the collateralised Bank of England has had its pound of flesh, there might be nothing left.

Bank attacked over Rock rescue

The Bank of England has got itself into a terrible muddle on the issue of when it is appropriate to bail out markets. A fierce rearguard campaign was being fought by the Bank yesterday to explain why helping to tide Northern Rock over is completely different from flooding the system more generally with liquidity – something the Bank has resisted. Yet it's an intellectually quite difficult distinction to make, and I'm not altogether sure it stacks up.

Only last Wednesday, Mervyn King, the Governor, implicitly criticised his opposite numbers at the European Central Bank and the US Federal Reserve for giving in to the markets and providing vast quantities of distress finance. The effect, he said, was to penalise those financial institutions who sat out the dance, encourage herd behaviour and increase the intensity of future crises. So how come he's now come riding to the rescue of Northern Rock? It is a moot point as to whether this would have been necessary had the Bank provided the liquidity it dismissed as unjustified just a few days previously.

The distinction made by the Bank of England is between providing the markets with a free ride and the need to prevent the panic that would erupt in the bank payments system if Northern Rock or other individual banks were allowed to go to the wall. Willem Buiter, a former member of the Monetary Policy Committee, was vocal yesterday in arguing that the mortgage bank should have been left to its own devices. There's a deposit protection scheme to underwrite savers' money, he points out, and the system would therefore have survived a Northern Rock collapse.

I can't agree that this would have been the right course. Think of the scenes as Northern Rock depositors began to realise they couldn't get their money back – boarded-up branches and an angry mob. Pretty soon people would start to think that if Northern Rock can be allowed to go under, perhaps others would be, too. There would be a generalised run on the banking system and an already serious credit crisis would turn into a rout.

Even so, the Bank has not handled the present crisis well. The Old Lady's systems and frameworks have looked cumbersome, obscure and inflexible, and, rightly or wrongly, there is a perception in the City that the Bank hasn't properly grasped the gravity of the situation. Standing on the sidelines while other central banks acted certainly looked principled and brave, but it may also have been foolhardy.

Still, let's not jump to conclusions quite yet. It's still a bit early in the search for scapegoats to be stringing the Governor up from the nearest lamp-post.

Housing correction looks inevitable

What began as the proverbial storm in a tea-cup has turned into a financial crisis of grave proportions, with possibly now quite significant knock-on consequences for the wider economy. Never before have I witnessed queues of anxious savers forming outside the bank to get their money out – an old-fashioned, 19th-century banking run, if you like. Yet this is only the outward manifestation of a much wider loss of confidence in the money markets.

Northern Rock, until recently the provider of one in every five mortgages sold in Britain, is now effectively out of the new mortgage market altogether. Other lenders too are crimping their lending and increasing their rates. A housing market correction now seems inevitable, and perhaps particularly so in London, where boom conditions have been fed by City money. That source of demand may be over for the time being. On one level, all that's happening is a return to normality after the excesses of recent years. Yet for many, the comedown will be painful.