Ten years ago Northern Rock disappeared in a cloud of smoke and mirror practices, opacity and mistrust. Richard Murphy asks, what have we learnt for the next time?
It is almost a decade since Northern Rock failed. The former building society, and doomed bank, suffered the ignominy of being the first UK bank to suffer a run on its cash reserves in 140 years during September 2007. As one of the most acute observers of the bank at that time, I question whether the lessons from Northern Rock have really been learned.
What I did in September 2007, as Northern Rock was very obviously going bust, was to ask why it might be that the bank was in such trouble. On 17 September 2007 I published details of its corporate structure, revealing that far from being a simple building society turned bank, Northern Rock was little more than an exercise in financial engineering that had gone badly wrong.
It is important to remember that a building society does what most people think banks do: they accept deposits from people and lend them out again. That, contrary to popular belief, is not what banks do. Instead, using the banking licence that is granted to them by the Bank of England, they make new money “out of thin air” whenever they make a loan. That new money is created in an alarmingly simple deal based on two promises to pay. The customer promises to repay the bank; in exchange the bank promises to pay the funds it creates for the customer to whomsoever the customer dictates.
No one else’s money is involved in the deal. The bank enters a credit in the customer’s current account for the loan amount and it enters a debit of the same amount in the customer’s loan account. So money is created by the simple promise to pay.
What Northern Rock did as a new bank that had previously been a building society was abuse this money-creating facility that all banks have. Between 1998 (the year it became a bank) and 2007 (just before it failed), Northern Rock’s total assets grew from £17 billion to £113 billion. This incredible rate of growth had made it the fifth largest UK mortgage bank by the summer of 2007. That growth was achieved through a high-risk strategy.
Northern Rock granted mortgages at up to 125% of property values, assuming that perpetual property market growth in value would soon make up any difference and so make up any shortfall in security quite quickly. And it granted loans to people who certified their own incomes, seemingly ignoring the fact that not everyone is honest.
Putting these two factors together Northern Rock created a flood of new loans (and so money). But a problem with growth on this scale arises because, while a bank may be able to conjure loans from nothing, it also requires working capital (cash) to fund its operations, especially if they are growing at pace as Northern Rock’s were.
While banks can create money for other people by creating loans, they can’t do that for themselves. So they need either to borrow money or sell shares in their business. Either way the prospective lenders and shareholders have to be convinced that Northern Rock was able to repay. And that’s where the problems arose.
While a bank may be able to conjure loans from nothing, it also requires working capital.
Northern Rock, like all former building societies, used its depositors’ funds as part of its working capital. But such was its rate of growth that it was especially dependent upon loans from financial institutions to provide it with working capital. To the public they offered above average rates of interest to keep the funds flowing. To the institutions they sold repackaged mortgages, which were the vogue of the period, and at first they bought all that Northern Rock had to offer. But there were three problems.
First, this repackaged debt was low quality yet it was rated as investment grade. It comprised mortgages, of varying quality, in batches worth, when the process started in 2000, a few hundred million pounds. By 2006 the packages were worth up to £5.4 billion. The investment grade given to the debt by rating agencies was misleading. The reality was that many of the mortgages being repackaged for sale were low quality because of the way in which they were sold. Despite this the lenders and shareholders were taking on more than 96% of the mortgage risk in many cases, leaving Northern Rock with only 3% or so, and little incentive to pursue mortgage debt as hard as they might.
Second, most of this debt repackaging was through what might quite appropriately be called Northern Rock’s shadow bank. This entity – called Granite – was supposedly independent of Northern Rock. This apparent independence was achieved through a complex sham. Granite was not legally owned by Northern Rock but was instead supposedly controlled by a trust set up by Northern Rock. The declared beneficiary of this trust was a charity called Downs Syndrome North East (DSNE). But no one in Northern Rock thought to tell the charity that its name was being used in this way, and nothing was ever paid to it. So mortgages worth tens of billions of pounds were apparently being managed on DSNE’s behalf but it neither knew of, nor saw a penny.
The sham became clear when it emerged that the shadow bank had no employees of its own.
Northern Rock managed Granite’s affairs to sell its repackaged mortgages on to other banks and investors through a series of entities such as Granite Mortgages 04-2 plc, which were used for this exercise. And for added opacity there was an offshore element. Much of the debt repackaging took place through Jersey.
Third, and arguably most importantly, there was little transparency and so no direct line of sight to reveal Northern Rock’s activities. The entire Northern Rock/ Granite house of cards was not apparent to the media or most people including government. I recall the effort it took me to persuade any journalist that unless Granite, and the 40% or more of Northern Rock’s mortgages that it managed by 2007, was taken into account I argued that the whole debacle of its collapse could not be understood.
My argument was ultimately widely aired. Nick Mathiason published a series of articles based on my work in The Observer. And John McDonnell and Vince Cable realised that Northern Rock was a perfect example of the banking shambles that the UK and US had, as a result of light-touch regulation, helped into existence. They said so during the debate in the House of Commons when Northern Rock was nationalised in February 2008 when they sought clarification as to whether Granite was to be included in the deal or not. What was quite clear was that the government was unaware at that stage.
The mass confusion was the product of a mix of dubious rating agency reports on products that could never justify investment grade rating, offshore involvement, abuse of trusts, financial repackaging and financial product mis-selling. Behind the facade there was just an opaque financial pyramid. At its base were so many people who had been sold mortgages they could not afford that the whole edifice had to come crashing down.
And it did. Its continued growth was wholly dependent on selling more and more mortgages. And that required increasing working capital to ensure it had the liquidity to meet the demands made on it to settle its own promises to pay. But when the market for the repackaged mortgages realised that their quality was poor, which happened as 2007 progressed, the market for its debt dried up. This is what caused its failure.
So when the public heard in September 2007 that Northern Rock’s promise to pay was not worth the paper it was written on, the queues began to form outside its branches. The run on the bank began and its end was inevitable because Northern Rock’s promise to pay was not considered to be good.
And ten years on we have still not learned enough from this debacle.
Few people still understand how banks really work. Offshore opacity still exists. The abuse of trusts remains commonplace. And while it would be hard to recreate the Northern Rock scenario now, product mis-selling continues. It just moves from product to product: it now looks like car loans may provide the next scandal. Meanwhile debt repackaging has returned to the market, even if not yet on the scale of 2007. And the financial services industry guards jealously its capacity to maintain offshore opacity.
We have had change since 2007 but not enough. The next financial crisis will not be the same as the last one but we have not extracted nearly enough from the experiences of 2007 to prevent it happening.
The danger that arises when transparency is poor is arguably chief among the lessons from the Northern Rock story. Until we learn that lesson and apply it, the next crisis will remain just around a corner. Further improvement in transparency will reveal what is around that corner and take us on the first steps towards tackling it.