Northern Rock – A Bank Built On Sand?

The confirmation by the Bank of England of support for Northern Rock plc on 12 September 2007 is the first major sign of international fallout from the collapse of the US subprime mortgage lending market.

In the US, lenders such as New Century Financial Corporation, the second largest subprime lender in California, have gone bankrupt. In the UK, as Northern Rock is classed as a bank, the authorities intervened in order to prevent market panic. There have been persistent rumours that several leading UK banks, including Barclays, have liquidity issues and the Bank of England wished to send a clear signal that no major bank will be allowed to fail.

The irony of Northern Rock is that it was generally deemed to be a successful company. The share price was GBP12.58 in February, but by 14 September 2007 it had dropped to GBP4.33.

Northern Rock achieved sales growth by offering 100% mortgages on home valuations, plus an extras 25%. Their projected growth rate was 20% per annum and yet the market was only growing at around 10%. In order to gain this volume of business, they needed very attractive mortgage products and also to adopt a flexible approach to consumers with mixed credit records.

They were so successful that they gained 22% market share of all new mortgages taken out during the first 6 months of 2007. The growth in the issue of mortgages was primarily funded via the wholesale market, as opposed to deposits by individual savers. It is estimated that some 75% of funds come from this source. The near collapse of interbank lending in August effectively starved Northern Rock of funds and caused a liquidity crisis.

In comparison to the US subprime scene, Northern Rock appears almost prudent. New Century of California took such a lenient view on customers’ poor credit ratings that it allegedly would make advances to a person who came out of bankruptcy on the previous day. Northern Rock, on the other hand, has not been accused of failures of diligence in its lending policies and mortgage risk assessment methods. Northern Rock has not been hit by mortgage defaults, but by a lack of finance which is required to fund its ambitious expansion.

The housing market in the UK is now set to follow the downward trend of the USA. Prices have dropped by more than 10% in some locations such as Stockton, California, where the repossession rate is running at 3.7% of households.

Despite the differences between Northern Rock and the bankrupt US mortgage lenders, the root cause remains the same. This is the persistent growth of consumer debt.

In the UK, the average level of household debt, excluding mortgages, is GBP8, 856. Average household debt is GBP56,000 if mortgages are included. It should be noted that these are average figures and they include a large number of households who do not have mortgages or credit card balances.

Some 11.8m UK households have mortgages and the average amount outstanding is GBP96,560. In addition, if non mortgage debt is limited to the households with unsecured loans, mainly credit cards, then the debt figure rises to GBP20,600. Therefore the average total debt of households with mortgages and credit card loans is a staggering GBP117,160.

Although the USA figures are calculated in different ways, average credit card and car loan debt is US$18,700 per household, and mortgage debt is US$74,000.

In both countries, but especially the UK, the increase in consumer debt is based on the expectation of rising house prices, full employment and low interest rates. If any of these conditions change, then the results will be serious if not catastrophic.

The growth of the UK economy over the last 20 years, has been driven by the steady increase in house prices and underpinned by North Sea oil. During this time, the manufacture of goods in the UK has continued its secular decline as has the number of British owned firms in both the manufacturing and service sectors. The major growth sector of the economy has been financial services and the City of London, which has eclipsed Wall Street.

In both countries, the dampening of inflationary pressures due to cheap imports, is unlikely to continue indefinitely. The process of globalization is almost complete. Wages and material costs are set to rise in China and other far east manufacturers, and this imported inflation will bring to an end the period of consumer led growth in both the USA and UK. This will inevitably lead to period of re-adjustment, during which time interest rates could well rise to double digits.

In the meantime, the uncertainty surrounding financial institutions will continue to unnerve both the housing and stock markets of the western economies. Investors seeking serious returns need to look further afield, and borrowers need to reconsider their ability to repay loans in the event of a significant rise in interest rates.