In the early hours of Friday 14 September, the Bank of England announced that it had made funds available to Northern Rock because it could not raise money on the normal money markets.
As day broke on Friday, we saw a sight not seen in this country for a century – queues of people outside a major British Bank wanting to take all their money out of the bank. A good old-fashioned run on a bank. Reminiscent of grainy black and white film of the USA in the Great Depression when so many banks went bust.
As the bank's Chief Executive, the Chancellor of the Exchequer and various other pundits sought to calm the situation by saying that all was well with Northern Rock's core business, the queues continued unabated. By Tuesday, with billions of pounds withdrawn, the government decided to guarantee all deposits with the bank.
Northern Rock has gone, in a few years, from being a small, regional building society to become Britain's fifth largest mortgage lender last year, and probably the biggest mortgage lender in the first half of 2007. It has done so by offering mortgages that most other banks would not consider, e.g. loans of up to 5 or 6 times income, loans of up to 125% of property value. But, at the same time, Northern Rock claims that its arrears record is as good as, if not better than, the industry average. The Daily Telegraph, on 14 September, reported that its arrears were only half the industry average. How is this done? I suggest that it is all done with smoke and mirrors. Read on.
Northern Rock offers what it brands as the Together mortgage. With this mortgage, the borrower can borrow up to 125% of the value of the property. The loan is structured so that the borrower takes out a conventional mortgage of 95% of the value of the property plus there is the facility to borrow as a personal loan up to another 30%. So what happens is that, in most cases, the borrower may take out 95% plus, say, another 5-15% to cover the deposit, moving costs, new furnishings etc. It is unlikely that a borrower would take the full 125% on day one. However, at this stage, the borrower may have borrowed over 4 times their income. Monthly loan repayments will account for nearly half the net income of the borrower. Within a short period, it is likely that the borrower will be struggling to meet the monthly repayments. In normal circumstances, this would then show up as arrears. However, with the facility to borrow another 15-25% of the property value already agreed by Northern Rock, the borrower can access these funds at short notice and this will cover their normal monthly payment. Hence, no arrears show up. A few months later, ditto. For quite a few years, any potential arrears will be masked by the drawdown of the personal loan facility. So Northern Rock can boast of its great arrears record. Until, at some point, thousands of borrowers are borrowed up to the hilt of 125% of the initial property value and not a hope in hell of keeping up the repayments. But that is a problem for the future.
To quote from the Northern Rock website, "Once your unsecured loan is set up, all it takes is one phone call to request an amount of money which will be transferred to your bank account within three to four working days. You can use the unsecured loan part of together for any legal purpose." See full details on Northern Rock website.
When the vultures circle around Northern Rock, they will, presumably, work out the scam that has been going on. They will realise that the true value of the Rock is probably negative. At this point, the banks do a deal with the government. They will agree to bail out the Rock but in return for this they will exact a price: continued light touch regulation of the banking industry plus a deal on penalty charges.
Watch out for the takeover of Northern Rock for a nominal sum; and a few weeks later, the OFT announcing that they have reached a brilliant deal with the banks over penalty charges. No need for the test case; innovative solution to a difficult problem; all is well in the world. Drinks all round.
Well not quite drinks all round, because at that point all the claims in the court system will have to be brought to a conclusion. The banks will settle them as quickly and as quietly as they can manage. They will hope that the steam has gone out of the bank charges campaign. But, they will be wrong. We will continue the battle for years to come.
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