Northern Rock: A Busted Bank?

Northern Rock has sought emergency funding from the Bank of England. Although its share price has been trashed, there is no danger of it going under, so relax!

Yesterday evening, rumours began circulating that Northern Rock, the UK's fifth-largest mortgage lender with a 7% market share, was in trouble. The BBC reported that Northern Rock had approached the Bank of England for emergency financial support.

This morning, Northern Rock issued a statement to the London Stock Exchange which warned that, in common with other mortgage lenders, it was having difficulty raising money on the wholesale money markets. In other words, it was experiencing difficulty funding its day-to-day requirements and had therefore sought a short-term line of credit from the Bank of England (BoE) in order to improve its liquidity.

It is quite normal for the BoE to act as a ‘lender of last resort' for banks struggling to raise funds.In simple terms, Northern Rock has a credit squeeze and is a bit short of cash, so it has therefore agreed a form of temporary overdraft (costing a mere 1% over base rate, or 6.75% a year) from the BoE.

Nevertheless, this announcement has spooked savers with Northern Rock: today's edition of Working Lunch on BBC2 showed long queues outside Northern Rock branches across the country. Northern Rock is suffering more than most because it has been aggressively increasing its market share by offering cut-rate deals and lending high multiples of income (up to 5.9 times before-tax salary!).

So, let's get one thing straight: you must not scamper off to your local branch to withdraw your life savings from Northern Rock. Nor should you try to access Northern Rock's online banking facilities, as its website is under severe pressure and has all but shut down. The simple fact is that there is no way on earth that the powers that be would let such a major financial institution go to the wall, so don't panic! Indeed, by all rushing to withdraw your savings, you make things worse, as you make it even harder for Northern Rock to manage its funding requirements.

For the record, Chancellor Alistair Darling, the Bank of England, HM Treasury, the Treasury Select Committee, the Financial Services Authority (FSA), the Council of Mortgage Lenders (CML) and the British Bankers' Association have all lined up to confirm that Northern Rock is in no danger of going bust.

Indeed, it has £113 billion of loans and assets and £24 billion of deposits, which together come to almost £5,500 for every household in England. Northern Rock has 1.5 million savers and 800,000 mortgage borrowers, so there must be 2.3 million worried people today!

Today's big losers are not Northern Rock's savers and borrowers, but its shareholders, as it cut its profit forecast for 2007 by £147 million. Investors have seen the value of their shares fall by around three-tenths (30%) today, on top of steep falls earlier in the year. Indeed, Northern Rock's share price has collapsed from a high of £12.58 on 6 February 2007 to just £4.45 at present. Ouch!

Despite today's profit warning, the stock market still values Northern Rock at £1.9 billion, it will still make a profit this year, and it has a strong loan book. Its problem is purely one of liquidity and funding, not lending quality. Even when more of its mortgages turn sour in the coming housing slump, it will remain solvent and certainly won't go bust.In response to this news, the rating agencies cut their credit ratings for Northern Rock.

Standard & Poor's Ratings Services cut its long-term counterparty credit rating on Northern Rock from ‘A+' to ‘A' with a negative outlook. Fitch Ratings downgraded Northern Rock's long-term issuer default rating to ‘A' from ‘A+' and its individual rating to ‘B/C' from ‘A/B'.So, this is in no way similar to the secondary-banking crisis of the Seventies, when over sixty small banks went bust or were bailed out by other banks.

Then again, Northern Rock is not alone in having difficulty managing its daily cash requirements. As I warned in Mortgage Rates Rise As Banks Struggle, Abbey, Standard Life Bank and now Halifax and Bank of Scotland are raising their variable mortgage rates in response to the ongoing credit crisis.

Thus, although investors are suffering from a lack of confidence in the future profitability of banks, we're pretty far from experiencing a meltdown in British banking.

Still, I've no doubt that Northern Rock's move will open the door for other mortgage lenders to approach to the Bank England in order to improve their liquidity. The stock market agrees, as the share prices of banks have tumbled across the board today. Nevertheless, if things took a turn for the worse, the Bank of England would probably instruct one of the mega-banks (most likely mortgage giant HBOS) to take over Northern Rock and assume its liabilities.

Indeed, the collapse in Northern Rock's share price makes its highly susceptible to a takeover by another bank -- no doubt mergers and acquisitions teams are already doing their sums. Finally, this news seems to be the final nail in the coffin of ever-rising house prices.

The crisis at Northern Rock will put even more pressure on mortgage borrowers, making it even more difficult and expensive to purchase a home. The values of commercial property and the share prices of property businesses and mortgage lenders have plunged this year, and it's only a matter of time before domestic property prices follow suit. The dream decade of cheap credit is over and it's now wake-up time for overburdened homeowners!