Friday, February 22, 2008

Northern Rock - who's to blame?

I've finally managed to catch the Dispatches programme regarding Northern Rock. It seems the fault lies with everyone, except the presenter who'd warned everyone about what was about to happen. We were greedy wanting low interest loans, the financial institutes wanted big profits, and not one of the three regulatory bodies knew which one was in charge of all this.

Other then the repeated "I told you so"'s from the presenter the programme was quite informative. Rather then tell you to watch its hour-long length I'll break it down into a Q&A session.

What's this sub-prime thing?

Easy-peasy you lend money (particularly mortgages) to people who are unlikely to be able to pay it back. Yep sounds stupid, but because they can't get loans elsewhere you can charge a hefty wad of interest, those that do manage to pay offset those who default with a little bit extra as profit. Better yet on mortgages you get to keep the amount already paid, and sell the property to make up the shortfall - it's foolproof; so long as you don't mind loaning money to people who can't afford it.

So what's sub-prime got to do with pension schemes and investments?

Well Wall Street devised a neatly acronymed product that meant you could 'buy' mortgages in a lump and suck the profit out of them. The best profit margins occurred in the sub-prime market so that's what everyone 'bought' except they didn't real buy them they themselves took a loan out to buy them.

How do these loans work?

Well an investment firm might borrow $1bn at 5.4% annual interest; that means they're paying $54m a year, then buy sub-prime 'chunk' that was making $80m a year. So an instant $26m a year profit on a perpetual loan. Everyone was making money, so everyone was happy.

But what happens if you get a lot of the sub-prime market defaulting at the same time?

Won't happen. In fact we know it won't happen because the sub-prime market got marked by the Credit Assurance companies as triple-A which is the same as the Bank of England would get. Don't worry that these assurance companies work for the people selling the investments, and don't worry that they've only dealt with company investments and never even examined domestic investments before. Triple-A rating means they're safe.

But the market did start to fail didn't it?

Yep, then the profit started to become less then the interest required to pay off the loans and everyone started to lose money in a big way. The big financial institutes saw this coming and started to prepare big cash cushions to soften the blow, in order to do this they had to cut back on lending out money.
So what's this got to do with Northern Rock?

Well Northern Rock's business plan was based upon the ability to constantly borrow money, a bit like how the sub-prime mortgages were 'bought' just in greater quantities and smaller lumps. So when all the major finance houses started cutting back on lending their source went dry.

Didn't anyone spot the flaws in the plan?

Yep the Bank of England did except they no longer handled that side of things, that was down to the FSA who though it was all hunky-dory. Nor did the Treasury, who formed the third part of the triumvirate regulatory system, see any problems or possibly even look for any.

So then the Bank of England loaned out some cash to them.

Yes, because no-one else was doing it, the Bank of England under regulation had to loan the money out; then again apparently under regulation let everyone know.


Yeah the media got a hold of it, then blew it all up, and pretty much started a run on the bank.

So what lessons have we learned?

Well an investigation is being carried out as to why the FSA failed to spot the flaws in the business plan, said investigation being carried out by… the FSA. We also have legislation being devised to prevent reports of emergency loans starting runs on banks by allowing the BoE to make covert loans i.e. not tell anyone what they're doing.

We are also waiting for the next big shockwave in the sales of guarantees as companies heavily invested in the sub-prime market were underwriting said guarantees. Well I say we're waiting, I mean you, me, the people who watched (and understood) the programme, and the finance houses are waiting; as far as anyone knows the FSA, BoE and Treasury still haven't got a clue what's happening.

No really what lessons have we learned?

Greed is good, for the investment bankers and their big bonuses. The invisible hand of self-regulation didn't work. Our underpowered regulatory bodies are woefully behind the times. And finally if you can't stop the next one, just make sure you can hide who's to blame easier. Oh and make sure to blame the Americans for starting it and not our own firms for latching on to the idea like lampreys.