Northern Rock: Are Building Societies Safer?

As building society-turned-bank Northern Rock struggles to stay afloat, we ask whether building societies are more secure than banks.

Sadly, the upcoming housing crisis has arrived early for investors in struggling mortgage lender Northern Rock. Last Friday's news that the bank had been forced to seek emergency funding from the Bank of England has caused Northern Rock's share price to plunge: it has fallen by nearly four-fifths (79%) since its peak on 6 February (£12.58) and now hovers around the £2.70 mark. Ouch!The shares floated at £4.52 on 1 October 1997, when Northern Rock converted from a building society to a bank. Thus, many of its customers will regret holding onto their `free' shares in the Newcastle-based lender, as they are now two-fifths (40%) lower than at flotation. Clearly, Northern Rock is the biggest disaster among the "building societies turned banks" -- and long-term shareholders in Northern Rock have our sincere sympathies.However, it's my belief that if Northern Rock had never converted to a bank, then it wouldn't be in anything like the mess it finds itself in today. In order to understand why I make this bold claim, you need to know something about the history of mortgage lending in the UK.A recent history of mortgage lendingUntil the Eighties, the UK mortgage market was, in effect, a cartel operated by building societies, as all societies charged the same interest rate. This rate was set by the Building Societies Association (BSA) in response to changes in the Bank of England's base rate. As all societies had a single mortgage interest rate, known as the standard variable rate (SVR), it didn't matter which lender you approached, as your monthly repayments would be identical.Back then, in order to qualify for a mortgage, you would have to open a savings account with your local building society. After being a member for, say, two years or more, you would eventually be invited to go cap in hand to your society manager for an interview. If successful, you would then use your savings as the deposit for your house purchase, borrowing the remainder from the society.What's more, strict regulations prevented societies from investing in pretty much anything other than cash and domestic property. In fact, they were even unable to invest in commercial properties such as shops, factories and other developments. Thus, thanks to these strict regulations, building societies were the bedrock of home-owning in the UK -- and became some of the largest and strongest mutual (member-owned) societies in the world.In the early Eighties, Margaret Thatcher decided that the mortgage market was anti-competitive. Through new legislation, she set out to turn this monopoly into a free market. This allowed banks to move into domestic mortgage lending, ending the building societies' grip on home ownership. Also, it gave greater freedom to the building societies, allowing them to diversify away from domestic property lending. Thus, societies were able to provide current accounts, credit cards, personal loans and other products.With banks and building societies competing for business, the newly deregulated mortgage market exploded, helping to aggravate the property boom/bust of the late Eighties. Nowadays, a couple of hundred different mortgage lenders compete for custom, with over 8,500 different mortgages to choose from. Today, the UK has one of the largest, most sophisticated mortgage markets in the world. Indeed, homebuyers can choose from a bewildering array of capped, cashback, current-account, discounted, fixed, flexible, offset and tracker mortgages! Are other lenders likely to follow Northern Rock? History lesson over -- now back to the banking crisis. Generally speaking, mortgage lenders raise funding for home loans in two ways: from depositors (savers) and from the international money markets (inter-bank lending). Northern Rock was very big in mortgage lending (note the past tense!), with £113 billion of outstanding loans and assets and 800,000 mortgage borrowers. However, it wasn't such a giant in the savings world, with only £24 billion on deposit from 1.5 million savers.Thus, Northern Rock relied on being able to borrow freely in the money markets. Indeed, it funded around three-quarters (75%) of its mortgage lending in this way, with only a quarter (25%) coming from its savers. Thanks to the effective shutdown in inter-bank lending caused by the ongoing credit crisis, Northern Rock was unable to fund its day-to-day needs in the money markets, which explains its anxious approach to the Bank of England.So, the big question is: are any other British banks and building societies likely to struggle to the same degree as Northern Rock? As few other lenders follow Northern Rock's low-cost, money-market-reliant strategy, my personal view is that this is most unlikely among mainstream lenders. Therefore, I don't expect to see major runs on any other well-known, high-street firms. However, we could see a few lenders on the `subprime' fringes follow Victoria Mortgages into the graveyard of administration.Then again, the stock market seems to have sharply marked down the share prices of mortgage lenders since last Thursday, as the following table shows:BankCurrentprice (p)Price on13/09 (p)Change (p)Change (%)Northern Rock270.75639-368.25-57.6Alliance & Leicester743937.5-194.5-20.7Bradford & Bingley294.75357.25-62.5-17.5HBOS818.5892-73.5-8.2Barclays577615-38-6.2Royal Bank of Scotland Group 509535-26-4.9Lloyds TSB Group511.5534.5-23-4.3Standard Chartered14551515-60-4.0HSBC Holdings881.5886.5-5-0.6As you can see, bar the Northern Rock, shares in Alliance & Leicester and Bradford & Bingley have been hit hardest over the past two days. A&L has aggressively expanded its market share in mortgages in recent years, and B&B has been a leader in the weakening buy-to-let market, which explains why Mr Market has beaten down these two shares.It's also worth noting that the market has more harshly marked down shares among the building societies turned banks. Alliance & Leicester, Bradford & Bingley and HBOS join Northern Rock in this group under fire. However, the big international banks, such as HSBC, Barclays, RBS and Standard Chartered have fared much better, with shares in global giant HSBC down a mere 5p since Thursday.In a nutshell, I believe that Britain's building societies are presently in a much stronger position than its banks. These member-owned societies don't have any shareholders, so it's impossible to say how they are doing in this market turmoil. However, regulations require building societies to fund at least half (50%) of their mortgage lending from depositors. Thus, no building society will have got itself into anything like the money-market mayhem which consumed Northern Rock.Indeed, my friends at Nationwide BS -- the UK's fourth-largest mortgage lender and its biggest building society -- tell me that it funds seven-tenths (70%) of its mortgage lending from savers. Thus, Nationwide BS is clearly in a much better position to ride out the credit storm than Northern Rock and other banks with similar funding models. What's more, I expect the building-society movement as a whole is in much better shape than the listed banks, thanks to its greater prudence in general.Finally, deposits in British banks and building societies are protected to some degree by the Financial Services Compensation Scheme. Thus, in this respect, all deposit-takers are all equally safe -- but some will undoubtedly be safer than others!More: Use our award-winning, no-fee mortgage service to lower your repayments | Mortgage Rates Rise As Banks Struggle | Great News From The Credit Crunch | Nationwide Versus The RestDisclosure: Cliff owns shares in HBOS and has a beneficial interest in RBS.