Tuesday, September 18, 2007

Northern Rock: Sinking like a rock...

Lately, Northern Rock, a UK based mortgage lender (whom I hadn't even heard of until very recently) has been in news for all the wrong reasons. It has found itself in the center of a classic bank run and is threatening to go under despite the Bank of England guaranteeing depositors' deposits. For those of you think a bank run is a marathon sponsored by a bank, this is what it really is:

Little people save some small change as they go about their daily business. They deposit their loose change in banks and sleep easy at night in the belief that all their loose change is now safe and is earning them even more loose change for them. Now, the way banks work is that they retain only a fraction of these deposits with them and farm out the rest into revenue generating activities. So, should all the depositors choose to withdraw their deposits at once, the banks don't quite have the funds necessary to cover all the withdrawals. This is about what happens during a bank run. Typically, things start with rumors about the bank's profitability and sustainability, at which point some easily-scared depositors worried about the bank's prospects, start withdrawing their deposits. A few more depositors watch these withdrawals and decide to withdraw their own deposits. So, a starts a trickle of withdrawals that turns into a steady stream and quickly into an unstoppable hemorrhaging. The problem the bank now faces is that it doesn't really keep all the deposits locked up in its vaults, so at some point the bank manager is forced to come out and say, "Ladies and gentlemen, can I have your attention please. I'm afraid we are having a bit of a technical glitch and can't quite service your withdrawals today. However, we would be happy to do so tomorrow. Please rest assured, your deposits are safe with us.... ". The depositors take this statement as a damning confirmation of their worst fears and the next day, even more depositors scramble into the bank for withdrawals, until a point when the bank collapses under the burden of sustained withdrawals and is forced into bankruptcy...

What's happening at the Northern Rock today is the typical bank run. What's not typical is Northern Rock's business model. Retail deposits form a small portion of Northern Rock's financing, and the mortgage lender's business model relied heavily on securitizing its mortgages and passing them further on into the financial system. This allowed Northern Rock to function with retail deposits funding just 30% of their operations and wholesale markets pitching in the rest of the 70%. But with large parts of financial markets, including inter-bank borrowing and the Asset Backed Commercial Paper (ABCP) segment, left frozen in the wake of the US sub-prime crisis, Northern Rock has found funding very hard to come by and its entire business model very much inadequate to deal with the situation. This has led to concern among its retail depositors about the viability of Northern Rock as a going concern and prompted the aforementioned bank run.

There's a couple of interesting things to note at this point. The first is that Northern Rock has very limited direct exposure to the US sub-prime mortgages. Most of its mortgages are higher quality AA-rated, and as such, run little risk of default. Northern Rock is suffering from a liquidity crisis that is has been induced by the sub-prime crisis. Investors are so spooked by the possibility of sub-prime exposure that all the liquidity has been drained out of the markets, even for essentially "prime" mortgages.

The second is that while the Bank of England has already stepped in twice to calm public fears about Northern Rock, first by promising the bank as much credit as it would require to ride out the crisis, and then by guaranteeing its retail deposits, the public sentiment about the bank still remains sharply negative. It serves to show that once it has gained sufficient momentum, a bank run is almost a self-fulfilling prophecy that not even the Bank of England can prevent.

I'm sure there'll be a few more twists and turns in the Northern Rock story in the coming days. Only time will tell whether Northern Rock will be able to pull through, and if it does, at what cost.... Bank runs would be so much fun if they weren't so tragic.... Well, until later.. cheers...


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