Northern Rock customers queue to withdraw their money
Between Northern Rock and a financial crisis
by Raphie de Santos
THE nationalisation of Northern Rock is the latest evidence of the breakdown of global finance and the rule of the market.
The nationalisation has come about not to save jobs but to the prop up the global finance system of which London is the epicentre. And it is being propped up with £100billion of ordinary people’s money. The crisis in Northern Rock’s has its roots in the low interest rate environment created by the US Federal Reserve at the turn of the millennium and the new types of financial strategies which flowed from this. This was further compounded by a toothless and inept UK financial regulatory body and UK Monetary Policy Committee blindly putting UK interest rates up in the summer of 2007 immediately prior to the subprime crisis braking in the August of that summer.
Roots of the Crisis
As short-term global interest rates fell on the back of the US Federal Reserve (Fed) cutting US rates to ease the fallout from the dot.com stock bubble bursting and a recession a whole series of financial strategies were developed by the financiers.
Under normal market conditions the rate at which you borrow money becomes higher the longer the length of time of the loan. This is to compensate lenders for the greater chance that a borrower may default and fail to pay the loan back in full the longer the duration of the loan.
But the Fed drove short-term rates down so low that the spread between shortterm rates and longer term rates was very large in most western economies. Financial transactions were designed in all sectors of global finance to take advantage of this spread. We have documented these in our previous article Money Market Madness.
Northern Rock’s management came up with one of the riskiest and ill thought through strategies as we will show.
The Bet That Blew Up
The old model of mortgage lending was that a financial institution tried to attract funds from depositors and pay them a rate of interest below those the financial market rate. These deposits are for medium and long term periods. They then could take this money which was deposited with them and lend it out for long periods in the form of mortgages at an interest rate above those available in the financial markets.
Making a nice fat profit on the spread between where they borrow from depositors and where they lend to mortgage borrowers.
As long as they could keep despoilers (lenders) with them or replace them with others they could carry on making money.
Northern Rock’s strategy was based on a new model. They borrowed short-term money from the London money markets at the low rates we mentioned above and lent it out for long periods of time to home buyers at much higher rates, making huge profits. As long as the highly rated banks that are the money market in London would be willing to lend to Northern Rock and at a rate where Northern Rock could make a profit on its mortgage business things would be ok. Northern Rock could carry on renewing these short-term loans in the money markets.
But two things happened in the Spring/Summer of 2007 which stopped Northern Rock doing this.
One, the UK monetary Policy Committee started to put interest rates up to curb inflation in the UK economy which was coming from cheap money and demand for raw material and food product from the developing world, in particular China.
Two, the sub-prime mortgage crisis broke in August 2007 and the money markets dried up as the banks stopped lending to each other and to smaller banks like Northern Rock because nobody knew for certain who was credit worthy anymore or who could go bankrupt.
As Northern Rock’s short-term loans matured they could not replace them with fresh loans at rates that were still profitable or the major banks would not lend to them because of doubts about its ability to pay the loan back.
On the Brink Collapse
At this point if the banks that had leant money to Northern Rock had called in their loans to them Northern Rock would not have been able to repay them as the money had been lent out to home buyers. Defaults by Northern Rock would have had a domino effect causing a whole series of defaults and bankruptcies in the financial markets. This is when the UK government stepped in to basically pay of the banks that had loans outstanding to Northern Rock. They have had to continue to do this as Northern Rock’s loans matured.
The government has so far given up to £110billion to pay off Northern Rock’s loans. £110billion of our money.
Hub of Global Finance
London is the hub of global finance because of its geographical position between the Far East and the US. The London money markets were where Northern Rock borrowed its money. It is they key money market fro global finance. It is where global financial institutions fund their day to day activities. It is the oil which keeps the wheels of global finance turning. The Northern Rock Crisis had the potential to have created havoc in the London money markets leading to global panic in all financial markets with a complete meltdown of the whole financial system. The government stepping to save Northern Rock was nothing to do about saving the depositors money but about saving the global financial system.
Western governments basically said to the UK government you have to step in and avoid a crisis. It your responsibility, Northern Rock falls under your watch.
Why Did It Happen?
Undoubtedly the Northern Rock management bear some of the responsibility for coming up with strategy in the first place and not thinking through the consequences of the strategy and factors which could change which would make the strategy impossible to be continued.
But the major blame for the crisis lies with the New Labour government. They created a financial regulatory framework that was totally inadequate for policing global finance in the UK. The framework was the brainchild of one Gordon Brown of which its backbone was the Financial Services Authority (FSA).
It was their job to protect ordinary people’s involvement with financial products and police the financial institutions. The FSA is packed with accountants and administrators and lacks the knowledge of the workings of financial markets and the products that are created by these markets.
They were unable to spot the flaws in Northern Rock operating model. The hedge funds and investment banks had and had been selling Northern Rock’s shares since the start of 2007 expecting some sort of collapse of its business because of it flawed operating model.
The UK government and the FSA where blind to this with the government encouraging the UK monetary committee to put up interest rates prior to the whole crisis exploding which only worsened the situation.
How are the government looking at the workings of the FSA? They have asked the FSA to carry out its own internal investigation as to what went wrong!
There needs to be an independent enquiry with independent experts from the financial markets taking part in it.
Believe it or not there are plenty of people in the financial markets with a social conscience and even some socialists.
Who Are The Losers?
The UK taxpayer or ordinary people are the main losers. The government may not be able to get any or all of our $110bn pounds back. The Northern Rock workforce will loose out through redundancy as the government wants to scale the business down dramatically.
They need to reduce the size of the loan book to reduce how much money they have loaned to Northern Rock.
They will do this by offering unattractive rates to borrow money from them for homeowners. This will be done to discourage new borrowers and make existing borrowers move their mortgages to another bank.
This will mean staff redundancies with up to 3,000 to go immediately.
Then more to go over time as the business is slowly run down.
The individual share holders will loose out. The bank is worth nothing and shareholders will receive a few pence to zero for each share they hold. The individual share holders are a mixture of staff who received shares as part of Northern Rock’s demutualization. These shares are effectively deferred wages.
The second set of shareholders is individuals who had accounts with Northern Rock when it was a mutual organisation. Again these are ordinary people from the North East of England.
The third group to lose out are those people whose pensions and insurance policies where invested in Northern Rock through fund management and insurance companies. Again this group are ordinary working people.
The only group of Northern Rock shareholders that socialists should have no sympathy with are the hedge funds.
Two SRM Global and RAB Capital, bought between them about 20% of Northern Rock expecting the shares to recover after the UK government intervened. Do we ask these organisations for compensation when they make money out of us? You gamble, which all this type of investing is, and you win some and lose some.
Anyway plenty of hedge funds made money out of the collapse of Northern Rock’s share price.
The Future?
Initially, Darling was claiming that nationalisation was a short-term solution but already Ron Sandler, the new chairman of Northern Rock, is saying that the bank could remain nationalised for years. Highlighting Darlings complete lack of understanding of the situation. No-one is going to buy a mortgage business in the current environment of increasing defaults and a tightening credit market unless they have offered a nice sweeter or discount. Darling found this out to the further tax payers’ expense to the tune of £100million - the fees to the city for receiving advice on Northern Rock’s sell off.
A socialist government could have nationalised Northern Rock, compensating the small shareholders and turning the bank into a social bank offering low cost loans to those in real need or who were struggling with existing loans to commercial banks.
Northern Rock crisis is part of a much larger crisis in the global financial system. The problem for the financial markets and ordinary people is that nobody knows where the next rupture in the system will be. There is 23 trillion US dollars of credit insurance guaranteed by global banks - most of whom have exposure to the sub-prime loan market as well. That’s three times the gross domestic product of the US. If we go into a deep global recession we can expect to see default rates of 5 per cent to 10 per cent amongst companies. This would mean that the global banks would have to pay one to two trillion US dollars in compensation. Without doubt this would lead to several bankruptcies in the banking sector leading to turmoil in the global financial system.
Global finance has clearly failed not just the poor of the developed world but working people in the western world. The time has come for it to be replaced with a rational system based on meeting people’s needs and ending poverty.