Anatomy of a Credit Crisis


By Sean Farrell

November 6, 2007

Northern Rock's collapse and Citigroup's disastrous losses stem from the same roots, planted a decade ago, but still not widely understood

With the credit crisis entering a new and possibly more dangerous phase, and Wall Street heads rolling left, right and centre, the question on everyone's lips – how did it come to this? – still needs answering. How come the head of the world's largest bank, Citigroup, has been forced to resign amid billions of dollars worth of losses on American sub-prime mortgage lending? How come the UK government is on the hook for more than £23bn of rescue finance for the relatively small, regional mortgage bank, Northern Rock? And, after the excesses in credit markets these seven years, are we now about to enter a new age of austerity which will poleaxe housing and other asset prices fed by the era of cheap debt?

Many factors have been blamed for the debt markets' travails, from greedy investment bankers to miscreant credit-rating agencies, gung-ho, fee-driven mortgage brokers, complacent regulators and the policy of exceptionally cheap money deliberately pursued by Western central bankers. Yet for the root causes of the crunch, you need to go back 10 years or more to the financial crisis that ripped through the emerging economies of the Far East. There are few more glaring examples of how the seeds for future implosions are sown in an earlier crisis.

Much of the money lent by the International Monetary Fund to bail out distressed economies had the effect of bailing out the Wall Street bankers who had lent to them with abandon. At the same time, extreme conditions were imposed on the IMF loans which in the short term enhanced the social and economic pain. It made many of these economies determined never again to let their destiny lie in the hands of others.

The upshot was that many of these economies began to save manically. Some of this money went into domestic investment, fuelling the now stellar growth of the region's biggest economies, but much of it went into rebuilding the foreign currency reserves, and hence into dollar assets. The same was true of the surpluses spilling out of the oil-rich Gulf states. The effect was to bid down long-term interest rates internationally. With low inflation globally, central bankers were able to keep domestic demand high by reducing short-term interest rates to exceptionally low levels. Indeed, they were more or less forced into this position by the huge trade surpluses being generated in the Far East, which in turn depressed business investment in the West.

Investors used to quite high rates of return found it hard to reconcile themselves to lower ones, driving liquidity into ever more high-risk endeavours. Financial markets were only too willing to help. All kinds of high-yielding exotic instruments were invented, and one of the most active markets was in sub-prime mortgage lending in the US. Low-income earners previously denied mort- gages were suddenly able to buy their own homes. The same financial engineering also drove the abundance of cheap mortgages in the UK.

By 1997, Northern Rock had followed other building societies such as Abbey National and Halifax to the market. While rivals diversified into insurance, business banking and fund management, Northern Rock "stuck to its knitting" of residential home loans. But the UK mortgage market was highly competitive. How could the Rock, with its small market share and tiny branch network, compete with giants such as Halifax? In the late 1990s, Northern Rock began to tap the growing debt markets to gain cheap funding for its growth. As it began to expand rapidly, the collision of the once-sleepy former building society with the global capital markets was set in motion. Securitisation allowed the Rock to generate cash and unload risk by parcelling its home loans as bonds and selling them to willing investors. When Adam Applegarth took over as chief executive in 2001, the bank increased its growth rate in a grab for volume and market share. By this year, the Rock was tapping the markets for nearly three-quarters of its funding – more than any other UK bank.

Since the bank's near implosion there have been plenty of voices saying they saw it coming. Yet reliance on the booming credit markets meant Northern Rock's problem was not risky lending but reckless borrowing. As interest rates rose, investors worried that pricier wholesale funding would squeeze margins and profits. But no one asked what would happen if there was a complete freeze in the markets that fed the bank's expansion. After the freeze on 9 August, it became clear Northern Rock was barely a bank at all. A senior source says: "Northern Rock was a gigantic SIV." Like a structured investment vehicle, Northern Rock issued cheap short-term debt to fund longer lending for higher yields. While SIVs invested in US sub-prime securities, Northern Rock sold mortgages. And, as with SIVs, when investors fled the markets the Rock struggled to refinance its debt as loans matured.

The run on the Rock began more than a month before queues formed outside branches, when |its wholesale depositors stopped lending. The Rock turned to the inter-bank market, but other banks were aware of its problems and had reined in lending. The Rock was doomed. In response to the crisis, the Bank of England and the FSA will step up scrutiny of banks to get a better understanding of their businesses. Regulatory checks are said to have focused too much on the quality of management and governance at the expense of the numbers. The monitoring of liquidity will be urgently upgraded and the Bank and the FSA are pushing for extra liquidity measures in the Basel 2 bank safety rules. The Bank of England has been lambasted by senior bankers for its apparent unwillingness to inject liquidity into the market early on to ease the strain on lenders. Mr Applegarth has claimed Northern Rock could have survived if the Bank had been as responsive as the European Central Bank and the US Federal Reserve.

But others argue this shows a lack of understanding of central banks' actions. When the markets froze, the Bank consulted the ECB and the Fed. They agreed there was no systemic threat to the sector and no big bank would go under. From this point, the central banks' responses to the crunch were more alike than is widely understood.

The ECB's eye-catching liquidity injections in early August appeared at odds with Mr King's lack of intervention. But the ECB's net injection in August and September was zero. Instead it just changed the timing of reserves because it believed banks would need more money at the start of the month and less at the end. The ECB did inject a small amount of three-month money but the average they got to each bank was £230m, adjusted for the size of the banking system. Northern Rock needed a hundred times that figure.

Unlike the ECB, the Bank of England does not decide the level of bank reserves. Instead, Britain's lenders tell the central bank each month how much money they want to keep on deposit with it. The Bank relaxed the margin for error on reserves for September because it thought the banks might have underestimated their requirements. It is also argued that though the Fed did inject liquidity the increase was at most 10 per cent and was mainly short-term money targeting the overnight rate.

On 13 August, Northern Rock told the FSA it was in trouble and the regulator set about trying to find a buyer. Talks with Lloyds TSB gathered pace, but Lloyds was worried about funding strain as the credit crunch bit. It told the Bank of England it would need up to £30bn of loans for two years to do the deal. The tripartite authority refused the request on |10 September because EU rules meant the Bank could not give preferential treatment to a single bidder. The talks with Lloyds ended and four days later Northern Rock's emergency funding was announced. Mr Applegarth told the Treasury Committee the deal collapsed because Mr King refused to extend lender-of-last-resort funding to Lloyds.This drew a rare public rebuttal from the Bank. It said Lloyds asked to borrow at the base rate of 5.75 per cent and that Lloyds pulled out before Northern Rock secured funding from the Bank at a penalty rate, believed to be at least 7 per cent. With no rescue deal and £27bn of Northern Rock's debt to be refinanced by the end of 2007, the authorities had to find a way to stop the wholesale run before the company went bust.

Northern Rock exposed the UK's threadbare measures for dealing with a bank in trouble. Mr King has contrasted events at Northern Rock with what happened at Countrywide Financial in the US. A run on Countrywide's deposits came to a swift end because customers were told that if the bank failed, their savings were guaranteed up to $100,000. By contrast, Britain's deposit protection scheme covered the first £2,000 of savings, 90 per cent up to £31,000 and no more. The Bank of England had long pressed for better measures to cope with a stricken bank but the Government had other priorities. The authorities are now working on long-overdue legislation. The Bank would have preferred to help the Rock discreetly. An auction of funds with no penalty rate would have attracted more banks, providing cover for Northern Rock. But ensuring the Rock would get the necessary funds would have required an auction of hundreds of billions of pounds. Lending on that scale would spook the markets. The only option was for the Bank of England to act as lender of last resort. But in attempting to stop the run by wholesale funders the Bank panicked ordinary savers and triggered the retail bank run.

The Northern Rock crisis was the first major test of the tripartite arrangement for financial stability that splits responsibility between the Treasury, the Bank and the FSA. The credit crunch has shown that the US is ahead of Britain in monitoring liquidity. The UK will have to tone down its regulatory hubris. Ultimately, responsibility for bank safety lies with the banks themselves. Mr King says the Rock could have taken insurance against liquidity risk, as Countrywide did in the US, but chose not to. It could also have financed itself with longer-term funding but opted for short-term markets, creating a fatal mismatch of maturities. The Bank believes Northern Rock took the risks and should pay the price. In the end, depositors kept their money and regulation will be improved to plug the holes exposed by the crisis. The affair will also lead to much-needed legislation to protect depositors and maintain confidence. Northern Rock put its business at the mercy of wholesale markets. Its rapid rise and sudden fall is a brutal reminder that, as a senior source says: "Banks are dangerous institutions."

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