Tuesday, November 20, 2007

Squalid as a Rock

There's been a lot of media hype over Northern Rock, and a vast number of journalists with limited grasp of economics or financial markets, blathering on about it, in a way that has in my view massively exacerbated both the run on deposits and the subsequent dive out of its stock. Sadly once again, I must conclude that this is (other than the usual British habit of press sensationalism) down to an inherent bias, which has been successfully inculcated in the common readership, against the "fat cats" who have apparently sent this country to rack and ruin by developing a sophisticated financial sector that appears heavily reliant on cheap debt. In turn, there is of course the mass hysteria and herd mentality that drives people to behave irrationally.

If one takes a look at Northern Rock's actual business model, we can see they were vulnerable to a complete dry-up in sensibly priced debt, because they had plumped for a strategy of borrowing in the wholesale market and taking an arbitrage (ie a bit of a margin) on lending out to the public as mortgages.

It's also worth noting that they have literally zero sub-prime exposure (ie loans to poor, broke people in crap houses), as their lending criteria have always been consistently conservative, which is how they got to be a FTSE 100 company with a decent reputation in the first place. They have a loan book that's 90% prime or near-prime residential (loans at risk of arrears were less than 0.5% last year, half the industry norm), a chunk of nicely secured commercial, and a sliver of unsecured personal loan exposure.

The entire sub-prime side they do have is actually secured by Lehman Brothers (anyone want to tell the media and send Lehman crashing down?!). I think even a complete moron (ie Alistair Darling) can understand then that Northern Rock's trouble is NOT because it is itself directly exposed to the sub-prime market, either here or in America, as most people seem to assume.

So the underlying security on the debt they owed back to the market is still there - it's just very illiquid. In fact, I think they still hold something like £95bn of assets in this way.

So what's the crisis all about? The way Northern Rock worked was threefold (note this is extremely simplified!) :

1. Use retail deposits (ie your cash in their bank accounts) to lend out to new customers. This gets hard when customers suddenly queue up and take £2bn of cash out.

2. Then package up blocks of this debt and sell it in the markets, and basically put that cash back in your account and/or make some fresh loans. Hence with a general credit crunch and concern about that kind of debt package (mortgage-backed securities), it became impossible to parcel up these loans and sell them (ie securitisation).

3. Just borrow directly in the capital markets (ie from other banks and institutions) for some fresh cash to lend onwards, but in the summer, the cost of borrowing exceeded how much they could charge to new mortgagees, so they had difficulty covering all that cash.

So they were basically stuffed by a model that relied too heavily on being able to use the markets to allow them to take on new loans and keep enough cash in circulation to make new loans - 75% or so of their money came from this rather than retail deposits. There is still exactly the same inherent security behind the bank as before (collateral), mostly in the form of a shedload of real estate which they have a first charge over.

Before the run on their cash, they had about £27bn of liquid assets (ie cash and other stuff they could lay their hands on easily). They also had a loan book (ie money out to customers) of £87bn. The money being put in by the Bank of England and the Treasury is covering loans to new customers, and securitising existing parcels of debt, because Northern Rock can't borrow competitively in the market at the moment. Otherwise the bank would grind to a complete halt and cause even more panic and devaluation.

Now the big question is what's securing all of that. The main statistic you hear quoted is LTV, or loan to value. This means how much leeway is there between how much the bank has lent against a particular asset, say a flat in Hendon, and what it's actually worth if the owner stops paying and the bank has to repossess and sell it to get its money out.

Right now, Northern Rock is sitting on a 2007 book average of 78% LTV, so unless there's a pile of defaults and a huge crash in property prices (nobody seriously expects anything more than stagnation), the loans they are making are really well-secured. Their historic mortgage book LTV is less than 60%. That £60bn of loan balance (£87bn-£27bn) is well-covered.

In other words, all this panic about the government losing £25bn is baseless. The issue is not IF, but WHEN and HOW it pays the money back, because this is a problem born out of liquidity issues from their unfortunate choice of business strategy, and because now they are in this downward spiral, other institutions will not lend them to pay back the government and resume normal business.

Besides, if you think Northern Rock is in a mess, take a look at HBOS, several times bigger, with assets of around £212bn and a loan portfolio of nearly £377bn - an exposure of £165bn, and in riskier market segments than Northern Rock. Guess what - it's not in trouble, well pretty much because nobody panicked, and it's in enough other businesses that it's not so reliant on the credit markets to keep liquidity.

So if you have a mortgage or savings account with Northern Rock, it's unlikely you are at any risk. If you are a shareholder, I'm afraid this is entirely at your own risk and as they say in the small print, the value of stocks can go down as well as up.

In real terms, if the bank had not been a public company with reporting obligations, they could have just shut up shop for a few months, not made any more loans except from retail deposits, and taken a hit on their profits. However, a quoted, listed bank that's in the FTSE 100 and one of Britain biggest, doesn't get that luxury.

The lesson here is that they were over-reliant on a single business strategy, which they did not have enough of a fallback plan in place for in the event of market turmoil, a hike in rates and the total absence of inter-bank lending and appetite for mortgage-backed securities. The shareholders have to take this on the chin - they invested because they believed in the bank's management to go with a winning strategy but have a hedge in place, and they were found wanting.

The only realistic course of action now is for everyone to stay the course and wait for Northern Rock to get access to some fresh debt by one means or another. The Bank of England is lending at "penal rates", albeit with interest rolled up - its base rate is at 5.75% and it's lending at something a bit over LIBOR (the basic rate at which banks historically lend each other), apparently at a rate of 7%. Effectively then, the Bank of England is going to make a profit when it gets its money back.

In practice this is not something Northern Rock can stick with forever and it means it may have to accept a take-over at any price, and get a decent new operator in charge who should be able to find a better lender. Citigroup have already offered a £10bn credit line, but unless LIBOR goes down a bit, they will charge more than 7% for the money, with more onerous conditions.

The alternatives are totally unpalatable - nationalise the bank and somehow hope to turn it round and still have to find new finance as part of any sale to retrieve "taxpayers' money", or simply run down the bank by not making any new loans, and finance out existing debt as and when possible (though predatory hedge funds and institutions will not go easy and will make a buck by buying these debts at advantageous rates to themselves). This would also crush the share price once and for all, and effectively see the end of the bank, with all those lay-offs - also unappealing.

The right thing to do may have been not to intervene other than guarantee retail deposits, and let the bank get gobbled up earlier and more painfully by sharks in the market. But I think that now the state has intervened, it has to stick it out.

Most of all, the press has to stop stoking the fire. This morning I called Radio 5Live's phone-in after one too many misguided members of the public called in to blame "the government for spending taxpayer's money" or "greedy hedge funds for getting us into this mess". I spoke to one of the producers, and he asked what I thought should be done. I said a good start would be to stop people voicing opinions that were not based on fact or any understanding of finance and economics.

He proceeded to have a massive go at me because "everyone has a right to an opinion". This is true, but they should not voice them when it's detrimental and amounts to corporate slander that, when taken on such a mass level and put in emotive terms like "900 per taxpayer" or "almost as much as we spend on secondary education", materially affects Northern Rock's ability to see this out, and hence (irony!) puts shareholders, Northern Rock employees, and the country's lent capital, at more risk.

The BBC is a leading culprit. But hey, it's a publicly financed body with no shareholders. Just as well, because it would never survive in the private sector. Imagine the shares on the slide as repeated misdemeanours come to light - phone-in scandals, failure to report objectively, massive bureaucratic waste etc. Unlike Northern Rock, where people can vote with their feet by moving savings elsewhere and selling their shares, I can be fined and given a criminal record for refusing to pay their licence fee, even though I disagree with their politics, think the standard of most shows has deteriorated, and find the standard of management appalling.

So if there is any multi-billion pound black hole that the government continues to pour money into, it's the one in White City, not the one in the City of London.

Friday, November 02, 2007


Just sat through the usual ITV emo-reportage about the poor hungry ill Palestinians, and how it was all Israel's fault. After showing some food trucks and warehouses, a man with colitis, some ambulances in a queue, plus a handful of rockets being fired (but of course none of them landing near Jews), then a rally of masked gunmen, we got an interview with someone from UNRWA, who blamed Israel for punishing "civilians" who have nothing to do with the rockets.

Did I miss something here? Those "civilians" voted en masse for Hamas, who are either firing the rockets or failing to stop them, then took sides in running internecine battles between various factions, who seem capable of uniting only to launch a few more rockets.

Meanwhile, Israel is supposed to supply power, water, fuel, food and medicine to these people. UNRWA and a sympathetic media can blame Israel for removing these services, but they seem to have forgotten the bit where the Arab world is sitting on the biggest reserves of oil and gas, a 25% stake in one of our major supermarkets, and where they and the Palestinian leadership have spent the last 60 years spending the money on themselves or trying to wipe Israel out, rather than build a Palestinian state worthy of the name.

But still, when Israel pulled out of Gaza, Jewish philanthropists around the world paid for the preservation of the massive greenhouses built on sand dunes, so a viable agricultural business could grow and the Palestinians could feed themselves. Instead, the "civilians" ransacked them.

The world gets very carried away by the little picture - individual suffering of ordinary people - which is heart-rending and unjust. But the injustice is being served by their own side - the perpetrators of violence - and the biased international institutions, politicians and journalists who think they are helping them - the perpetuators of poverty.

The big picture is pretty simple - have your own terror-led state whose main objective is the destruction of its neighbour, ululate on the street and hand out sweeties when Al Qaeda fly planes into Manhattan buildings, take pride in the death of every Jew, man, woman and child (perhaps even stone a couple of kids or shoot a baby), kidnap journalists who are actually favourable to your cause, scare the crap out of aid agencies who are usually also on your side so they have to leave, and you should pretty much expect to fend for yourself. Make peace, do trade, be stable, eat well etc etc.

The citizens of Nazi Germany voted for Hitler. They didn't then expect Londoners during the Blitz to send them food parcels or tankers of diesel. Why should the people of Sderot want to man the nearby gates to Gaza or the Ashdod refinery and do the same?