A Virgin Rebuffed; UK to Nationalize Northern Rock Plc.
Liquidity Risk
By blackhedd Posted in Bank of England | Banking crisis | Economy | moral hazard | Northern Rock — Comments (17) / Email this page » / Leave a comment »
According to news reports, the Labour government of Gordon Brown will nationalize Northern Rock Plc, one of Britain's largest retail banks. This is Britain's first bank nationalization in over twenty years, and the largest since the Bank of England was taken over after World War II.
A brief note by the bank to its customers is here.
What got Northern Rock into trouble? They took too much liquidity risk from mortgage-backed securities. Is it a good idea for Britain's government to be taking over a private bank? The answer is not necessarily "No."
Read on...
Based in Newcastle-on-Tyne, Northern Rock Plc. was one of the economic cornerstones of England's relatively poor (and Labour-voting) north-east. It has grown far faster by market share than its competitors in the last two years, by pursuing what had seemed like a brilliant strategy. Until it stopped being brilliant last August.
What is the liability that mortgage-originating banks typically use to fund their assets? Deposits from retail customers. The business of banking is, classically, all about borrowing money for short terms at relatively low rates, while lending it out for long terms at relatively higher rates. Of course, the risk in this model is that your short-term liabilities become too expensive to support your asset book.
This problem is minimal if your liabilities come from retail depositors. They generally tend to leave their deposits in place. But retail deposits are expensive to acquire. You need lots of bricks and mortar (aka, branch locations) and lots of customer services to do it.
The Rock, by contrast, funded about 75% of its mortgage book in the global credit market. Up until last summer, this strategy worked beautifully. Pooling individual mortgages into asset-backed securities and selling them to investors allowed the Rock to cut their cost of capital, while simultaneously leveraging the huge pools of liquidity that were then looking avidly for exposure to mortgages.
Good strategy. Until the day the world's credit markets suddenly froze solid. I remember the day well, August 8. I wrote about it the next morning here.
Northern Rock had traded the high cost and inflexibility of retail deposits for the high liquidity and relatively low cost of the global money markets. They were quite careful to diversify the resultant liquidity-risk across many different markets. It never once occurred to anyone, neither bankers nor Britain's banking regulator, that the liquidity might collapse everywhere, overnight.
What happened to Northern Rock on that day and in the subsequent several weeks is that they became unable to sell short-term paper to fund their assets. That's because no one, anywhere in the world, wanted to touch any security even remotely related to mortgages, or to do business with any bank whose book of business involved mortgages. (The latter effect is why LIBOR spreads shot up to abnormal highs that day, and have stayed abnormally high till just a few weeks ago.)
The Rock applied to the Bank of England (the UK's lender of last resort, analogous to our Federal Reserve and the European Central Bank) for an emergency liquidity facility, eventually borrowing tens of billions of pounds, guaranteed by British taxpayers. (The BoE, in a panic but greatly fearing moral hazard, imposed a high "penalty rate" of interest on the Rock's emergency borrowing.)
What then happened in mid-September, is that news of all these complicated doings leaked out to the public in a messy and improperly-controlled way. Wild rumors flew about, and were not coherently responded to either by the bank or the government. And Northern Rock's depositors panicked.
I said that 75% of the Rock's liabilities came from global markets. But of course the rest were from traditional depositors. At that time in Britain, only 2,000 pounds (about $4,000) of individual deposits were fully insured. And when depositors formed the impression that their bank, the pillar of their local economy, was in deep trouble, they did something not seen in the US since the early Thirties: they lined up to pull their money out of the Rock.
The run on the bank, which made headlines all around the world, actually wasn't the worst of the Rock's problems. Its stock price was also plummeting, threatening to wipe out the bank's capital. For simplicity, I'm finessing some other technical details that also impaired the Rock's liquidity at the time.
It's important to keep in mind that the sudden disappearance of liquidity to mortgage-related businesses was far out of proportion to any increase in the actual risk of default in the underlying mortgage assets. This is a very peculiar effect of modern financial markets, which have become extremely good at providing liquidity in normal times, only to dry it up like snowflakes in sunshine in times of stress. (I'll leave for another day the critically important but extremely complicated question of what, if anything, governments should do about this problem.)
After the run, it was very clear to everyone that Northern Rock was doomed, and the only question was how to wind the business down with minimum exposure to taxpayers, depositors, and (lastly) creditors. (The shareholders, as always, would go straight to... Hartford, Hereford, and Hampshire.)
You've read the news stories about Sir Richard Branson's Virgin Group Ltd., which bid for the bank. There were also attempts to sell it to a couple of private equity funds and to other, healthier, British banks. But none of the potential private acquirers have committed to immediately repay in full the loans that the BoE had made to Northern Rock in August and September. In the end, Britain's banking regulator decided that the best thing to do would be simply to take the bank over. This is the move that was announced today by Chancellor of the Exchequer Alistair Darling.
My esteemed fellow RedState contributor Pejman Yousefzadeh has opined here that the acquisition is wrong. Pej would have preferred a fully-private solution to the problem. I agree with him in spirit, but in this case there are major problems that counterindicate such a course.
The opportunity for a decent solution to the Northern Rock problem was lost back in August when the BoE chose not to liquefy England's banking system as the Fed and the ECB immediately and aggressively did. From that bad decision, which can be laid to BoE Governor Mervyn King, all of the subsequent badness flowed.
Northern Rock's stock price today is a small fraction of what it was before the crisis began. Even so, none of the private acquirers who have bid for the bank's equity have offered any more than a small fraction of even its current, depressed, valuation. That much is to be expected. It's also to be expected that a private acquirer would delay bidding as long as possible while the bank's troubles mounted, in order to get an even more favorable price.
And when all of the bidders but Virgin Group Ltd. dropped out, Virgin immediately reduced their own bid to respond to the reduced competition.
But the real problem is that Northern Rock now must be accounted not as the property of its shareholders, but rather of Britain's taxpayers, who have guaranteed the loans that are keeping it afloat. None of the private bids, including Virgin's, offered to assume this public debt, stipulating instead that they would acquire the bank's assets but leave its liabilities in the public's hands. In this way, they sought to get a deal in which they would face essentially no downside risk but enjoy all the upside potential, while taxpayers would get the opposite. The British government was right to reject these proposals.
The correct strategy here is obviously not for the BoE or Her Majesty's Treasury to run Northern Rock on behalf of Britain's taxpayers. There will probably be a lawsuit from the equity shareholders who will almost certainly be wiped out. The government should seek to liquidate the bank's operations in an orderly fashion, and take its time doing so. There is ample precedent for this in previous banking crises in other countries, like our S&L crisis of the late Eighties.
Two people who will come out of this episode smelling unlike roses are Mervyn King and Gordon Brown.
King is the head of the Bank of England (Britain's analog of Ben Bernanke). He has been sharply criticized for being more concerned with moral hazard than with the stability of the banking system in the early days of the crisis. While Bernanke and ECB governor Jean-Claude Trichet were injecting massive amounts of liquidity to keep the financial world from total collapse, King held out for many weeks. His excuse was that he didn't want to encourage bad behavior by mitigating its effects.
Gordon Brown, now Britain's Labour Prime Minister, was Chancellor of the Exchequer (equivalent to our Secretary of the Treasury) under Tony Blair. About ten years ago, Brown engineered a restructuring of Britain's bank-regulation system into three separate entities (the "Tripartite Authority"). For the first time, this system was put to the test this past autumn, and it failed miserably.
A Virgin Rebuffed; UK to Nationalize Northern Rock Plc. 17 Comments (0 topical, 17 editorial, 0 hidden) Post a comment »
...roughly two years to last summer. Whenever you see that, you have to assume there are problems of one kind or another. There were some indications of trouble in various parts of the operation. They reported lower gross margins in the early part of the summer, and their stock price fell somewhat as a result.
But these are "normal" problems that probably could have been sustained and improved on in the context of a basic business model that was working fairly well.
When the liquidity crisis hit, however, the whole model blew apart and their fate was sealed.
It's rather shocking that an entire industry should have proved so brittle in the face of a systemic shock. Britain's banking regulator, the Financial Services Authority, spent a good bit of time on Northern Rock, pressing them to stress-test their liquidity strategy in a variety of ways.
No one, but no one, thought to test for the eventuality that actually happened. And this is not a new story. No one dreamed that the events of August 1998 leading to the Long-Term collapse were in any way possible. Same with the October 1987 stock-market crash.
Blackhedd,
What do you think regulators here should do with the floundering monoline insurers?
Do you think they should separate the functions of insuring muni bonds from those insuring mortgage related obligations?
If they do so, should government absorb the downside of the latter while private equity investors get the upside of the former?
Or, as the decision is likely to be made by insurance commissioners (led by NY), should the multibillion losses expected from honoring guarantees on both policies and credit default swaps be backstopped by the entire insurance industry? And paid, one way or another, by all of us?
And, similar to Northern Rock, what should happen to shareholders of MBIA, Ambac, etc?
Just noticed this on Bloomberg. A billion here, a billion there, pretty soon it's real money.
U.S. bond insurers such as ACA may lose $34 billion on securities they guaranteed, Citigroup Global Markets said this month. They are likely to take losses of $32 billion on collateralized debt obligations backed partly by U.S. subprime mortgages, Citigroup said. They also may have an additional $2 billion in impairments on bonds backed by home equity lines of credit. CDOs repackage assets such as mortgage bonds and buyout loans into new securities with varying risk.
http://www.bloomberg.com/apps/news?pid=20601087&sid=azz9BzgsFxkk&refer=h...
...insurance-provider problem.
As you know, the problem is one of the localized disruptions caused by the systemic revaluation of mortgage risk. Insurance works perfectly well when you can underwrite risks in individual issues across a large pool, but when they all go bad at once, there's not much you can do.
The hit is just going to take place. A lot of value has already been wiped out. The investors, banks, hedge funds and other institutions that have had losses will just be licking their wounds, going out of business, and taking a lot less risk in the years to come. And this will certainly depress economic activity in the developed economies.
There's simply no way to avoid any of this. I suppose that the foul and disgusting Elliot Spitzer imagines he can be a hero on a white horse and somehow save the day. But I can't imagine any politically-disfavored party that he could stick with the bill. The losses are just too big, and they already are affecting everyone, not just people with upside-down mortgages or shareholders of Ambac and MBIA. You can't socialize them.
As far as splitting the monoline insurers into two books of business: that's not a solution to the big part of the problem. All that accomplishes is to allow the municipal-bond insurance business, which has always been and still is God-awfully lucrative, to continue with the same shareholders and management that blew up the mortgage-insurance business.
And Warren Buffett is seeing his chance to steal the good side of the business for himself. His offer to re-insure $800 billion worth of muni credits is his way of stripping the good stuff out of MBIA, Ambac, and FGIC and letting the rest of it die. Despite his avuncular image, Buffett is as ruthless and self-interested as they come. The managers of the monoline insurers, while they're forced to be polite in public to the man with the big checkbook, must be mad as wet hens at him in private.
were tottering as well.
The one I remember best was Republic Bank in Texas. It took over Interfirst when the latter got into trouble on energy loans. (and acquired the green neon-lit skyscraper that is a prominent part of the Dallas skyline.) The combined entity, First Republic, failed when the real estate market foundered next. Republic was THE establishment bank in Texas and the failure sent shockwaves across the Southwest.
The feds engineered the sale of the healthier parts of the bank to North Carolina based NCNB, which made out like a bandit. NCNB went on to become NationsBank and then merged with Bank of America, which of course is still around.
In the early 90's the feds pushed interest rates to rock bottom levels that were considered nearly inconceivable 5 years before, and that helped fix the situation.
I agree with blackhedd that the public interest can trump the natural desire for market-only solutions. Of course, the Brits were damn fools to have such skimpy deposit insurance!
The Republic-Interfirst situation you describe is a fairly classic example of what Schumpeter famously called "creative destruction" in business. I suspect that a lot of people think of business corporations as stable centers of power that can last for many years. It's easy to get that impression when you think of companies like Republic that are "the establishment" in a given region, or brands like Coca-Cola that have been around for more than a century.
It's certainly the case that Democratic Presidential candidates and their supporters look at businesses as independent powers that compete with the government, and naturally look at businesses as piggybanks for social spending!
But most businesses have to grow in order to survive. (The ones with tight ties to government are protected and face less of this pressure.) And to grow you have to take risk. And sometimes risk goes bad. When that happens, you have to recapitalize.
The brand names may survive and give an impression of continuity, but the business has changed in a fundamental way. And this happens every day.
All this by way of preface to some comments about deposit insurance.
Deposit insurance was very, very controversial when it was first established in the US. There had already been various deposit-insurance proposals for nearly 100 years back in 1933, when the predecessor of today's FDIC was established in one of the very earliest acts of the Roosevelt administration.
The controversy, of course, stemmed from discomfort with exposing the public to risks undertaken by private actors. Moral hazard, in short.
Of course, the early New Deal was a very special moment in American history, when disenchantment with free markets and private enterprise was widespread, and the people were all-too-willing to cede control over the economy to the Federal government.
In this climate, it was possible to combine a Federal deposit guarantee with the thing that made it less dangerous: tight Federal regulation of the banking system as a whole.
Over the next two years (1933-1935), the structure and responsibilities of the Federal Reserve System were modified and modernized to enable it to take the role of chief banking regulator, in addition to its already-existing role as a lender of last resort.
It would be possible to argue that this newly-established tight Federal control over the banking industry was one of the factors that created the credit-unavailability that in turn was the actual reason the Depression was as long and as painful as it was.
At one level, you have to judge that deposit insurance has been a success. We haven't had a run on any US bank at any time since 1933. (Even though the George Bailey movie wasn't made until the 1950s.) Bank runs had been a constant feature of financial panics since the US were founded. In fact, we think of the 1920's as a great decade for economic life in America, but the Twenties in fact were probably the worst decade in history for bank failures and other financial disruptions. And this was true around the world, not just here.
There's a lot more to this story, and it's all very interesting to a finance geek like me. But let's leave it by pointing out that deposit insurance, among other things, means that the taxpayers, through the agency of the Federal government, are automatically a party to any kind of disruption, distress or disorder suffered by a bank. That applies to individual banks that fail through poor decision-making or risk management, and to stresses that affect the system as a whole.
That means that there really is no such thing as a fully-private solution to any disruption in the banking system. Commercial and retail banking really is different from other industries in this regard.
Deposit insurance is just what the name says: insurance. It works by underwriting risk and spreading it across a large pool. But is it possible that some kind of systemic shock could affect the entire system, all at once?
That's one heck of a question.
But it is the job of central bankers to do their best that the question is just rhetorical.
There is a scene in "Gone With the Wind" as the O'Hara family contemplates destitution on the plantation. Scarlett's dad, who has gone insane, tells them not to worry because they still have money- in the form of Confederate war bonds.
Re George Bailey. The movie "It's a Wonderful Life" was made in 1946 and the action takes place in that year. The flashback scene with the bank run took place in the 1930's, so is true-to-life. George Bailey's postwar 1946 problems with the Building & Loan were due to the carelessness of one of his employees, who unwittingly delivered critical documents into the hands of the evil Mr. Potter, who seized the opportunity to shut down his troublesome rival once and for all.
Thank you for your analysis, blackhedd. I always learn so much more about economics every time I read one of your posts! I guess I'm wondering, though, what the free-market response should have been to this whole mess, even starting way back in August when the credit crunch really started for good. I'm as big a free-marketeer as the next guy, and in my view most of the problems that are attributed to the free market really have their origin in some sort of government regulation (i.e., distorting risks and rewards). However, would this be an example of a true market failure?
Alas I'm a UK taxpayer and will be footing the bill. I agree that subsidising Virgin or similar to run the bank would be daft to this is a better option than that but I am pretty hacked off that they are continuing to operate the bank at all.
Given that the bank lending wasn't too awful and it's reputation was pretty much shot, they should have simply auctioned off the loan book (whilst ensuring that the mortgage customers were fairly treated in the sale) and announced that the depositors deposits were guaranteed but the accounts would be closed in three months.
The reason they've got into this tortured mess is pure pork politics. They're desperate to avoid lay-offs as Newcastle is their turf. If this bank has been based in Surrey (Southern England, close to London, likely to vote Conservative) they would probably have closed it by now.
I can't see why they shareholders deserve anything other than whatever balance remains on the bank being wound up.
There's nothing wrong with that, and they knew the rules going in.
From what I've heard, the process you describe (slow liquidation and wind-down of the bank's businesses) is exactly what will happen.
I had also heard about the political implications of the fact that the north-east votes Labour. Thanks for giving us a confirmation of that! Based on those considerations, the wind-up will certainly be done such as to avoid layoffs.
There's another political consideration: since Northern Rock was originally de-mutualized from a building-loan society, I would guess that many of the shareholders are financially-unsophisticated individuals who got some of the original shares back in 1996. Since these people presumably also vote Labour, how much would you bet that they will be bailed out by the government?
Yep if there was one bank they won't let go to the wall it was this one. The area is solid Labour (http://news.bbc.co.uk/1/shared/mpdb/html/region_4.stm ) and the bank was, I believe, locally popular as it donated a percentage of profits to a local charity and sponsored their massively supported but perennially under-achieving football team.
While I think the biggest shareholders are now hedge funds speculating on a rescue, there will be a lot of local people with small shareholdings, either from the float or those that wanted to invest with a local institution.
They're in a muddle now, saying that it will be run commercially and take on new business, but also that they expect it to shrink rather than grow. Either way they have government-subsidized lending and a cast-iron deposit guarantee so I guess they'll go the predictable rout and steal business from private sector institutions that were too prudent to screw up like them.
The options were indeed limited. I really, really, don't like becoming the owner of a bank. (Technically, another bank, since I already own the Bank of England). I spent the 1980s and 90s selling my coal industry, natural gas supplier, electricity companies, airline, airports, telephone company and railway. I am keen to get rid of my post office, schools and hospitals.
But I am not sure that by now there was a better option than taking the thing over. Perhaps it should have been the Bank of England, not HM Treasury, that did it, but the difference is minimal.
There are, however, two distinct strategies still available. One is for the government to accept the strategy of Northern Rock's management and try to run the operation on a commercial basis and then sell it. This has the advantage that it could, theoretically, make back the money that the taxpayers have already spent, but only if government turns out to be much better at running banks than it is at, say, hospitals. Another advantage, of course, is that it would preserve at least some of those jobs in Newcastle.
The other, referred to above (and, btw, Blackedd, I believe that the government has rejected this idea) is to close the bank to all new business and slowly wind it up. Retail accounts could be closed along with the entire branch network. Mortgage payments would continue to come in and, eventually, all the outstanding mortgages would be cleared. This income would offset public borrowing. This seems to me to be the preferable option.
By the way, regarding insurance. There had not been bank run in the UK for 120 years. Which is why Gordon Brown is getting some funny looks over the fact that one happened within ten years of his new regulatory structure being put in place. If there is a second one this is going to look a lot less like bad luck and more like a bad judgement by our former Chancellor.
Quentin Langley
Editor of http://www.quentinlangley.net
International Editor of
...suppose that I or anyone working for me could run this bank for any length of time.
It seems reasonable that the existing management of the bank should be kept in place. However, under no circumstances would I reward them by offering them an equity stake. There is moral hazard enough in asking all the other banks to acquiesce to a competitor that is capitalized by the government.
At the very least, Northern Rock should be hobbled by needing to continue to pay the "penalty rate" (which I believe was 7.25% back in August) on the money it borrowed from the BoE. Of course, the opposite of this point is that this will make it very difficult for them to recover to profitability and eventually be sold to a new set of private shareholders.
It's a very messy situation. The best outcome may be a workout similar to what we did with the Resolution Trust Corporation: what we Americans call a "wind-down" and you British call a "wind-up." :-)
I couldn't say. In this instance the American usage seems to make more sense.
If you stop taking deposits and close the retail accounts you get past the whole 'moral hazard' issue. No-one will be borrowing from NR, so the fact that it can borrow at a cheaper rate than other banks is not a problem.
Incidentally, our bankruptcy laws have one thoroughly obnoxious feature and I was wondering if it also applied in the US. The Treasury is a 'preferred creditor' and taxes need to be paid before other creditors can be dealt with. I would put all government organisations to the bottom of the list, not the top.
Quentin Langley
Editor of http://www.quentinlangley.net
International Editor of
I can't say for sure how they would apply in this case. In many cases, the first people who must be paid are employees who are owed unpaid wages. Then come trade creditors, followed by senior debtholders, junior debtholders, and then shareholders. I'll be honest, I've never come across a bankruptcy case where there was a significant tax liability. More often, there is a tax-loss carry-forward that is treated as an asset of the company.
I do know that in cases of distress short of bankruptcy, the general practice of corporate directors is always to pay the government(s) in full, and to negotiate with everyone else.
But not all taxes are created alike. In some jurisdictions (including New York State), sales tax liabilities can't be defeased even in bankruptcy. After a corporation is dissolved, any remaining sales-tax liabilities become personal obligations of the directors and senior managers.
Dear Blackhedd,
Your comment above is on target, and appreciated. It points out that in the short term what sank Northern Rock was the disappearance of liqudity to the mortgage business.
I contend that even if the faucet of liquidity had not been turned off to Northern Rock, it would have failed in any event. This because the assets it was accumulating, matching against low-cost deposits, were bound to deteriorate: they were residential mortgages on single family properties purchased with insufficient downpayments, at top of market levels. Bank reports indicate the vast majority of loans were originated by brokers, not its own staff.
Further, the 46 billion pounds of securitizations most likely meant that one way or another, Northern Rock was selling off the most secure portions of its assets, while holding onto the riskier, subordinate tranches. There is no immediate way of proving this, but it is a trend which occurred at other mortgage bankers.
My intent here is not to nit pick your astute analysis. It is that you have (quite correctly) looked at the liability side of its operations. The asset side of its balance sheet was as wobbly as the funding which ran off in a blink.