October 2007

Don't knock the Rock!

THERE is no doubt about this month’s excitement — Northern Rock has been dicing with death. Except it wasn’t.

Northern Rock may be different from some of the other mortgage banks but it still has a lot to commend it – not least the Northern Rock Foundation which has been doing a great deal of good supporting worthwhile good causes in its area; a quality mortgage book; low arrears; and, at least until recently, a successful business model.

It has to be said that Northern Rock really is as sound as a rock – even before the Chancellor of the Exchequer unexpectedly threw it an unconditional guarantee.

That night, the most relieved individuals were not the NR directors based in Newcastle, as they already had full Bank of England endorsement, but some in Leicestershire, where a similar run on the Alliance & Leicester was fast picking up steam!

Although equally unwarranted, the Alliance & Leicester plc. had seen its share price collapse by over 30 per cent in the last half hour’s trading.

Without that Government offer of unconditional support, the panic withdrawals would have drawn full TV coverage and, fanned by the media, jumped from lender to lender like the recent bush fires in Greece.

At risk was the entire mortgage banking sector and, quite possibly, UK plc.

With its share price so low, the Alliance & Leicester – Britain’s seventh-biggest bank – quickly bought back £24.5 million of its own shares, its biggest buyback in seven years.

On average, its brokers paid around £7.60 a share and by the end of the day this support saw the share price recover by 32 per cent to £7.93.

No doubt the board of the Bradford & Bingley were also mightily relieved as the media had already started to stake out the B&B offices waiting for a crowd to arrive at the start of the next run. And TV camera crews attract a crowd without needing any justification!

So which rival bank will buy up the Rock? My guess, at the time of writing, is Lloyds TSB, despite the recent sales, but I did hear that even the National Bank of Australia was in the hunt. And do not forget the omnipresent Halifax.

When? Frankly that is dictated by the Bank of England; it will be in the small print of the loan agreement which gave the NR directors few options. I guess it will be gone by Christmas but the main criterion will be market confidence.

Whichever institution wins the auction will secure a bargain as, back in February 2007, the Rock shares were trading at £12.58.

They fell by over 80 per cent to £2.50 at one point as the queues grew and TV presenters were vying to find whoever had been waiting longest. But it is still a profitable business assuming the borrowers maintain their repayments.

Ironically, the Northern Rock – albeit a bank and not a building society – has always been prudently run.

The directors merely decided that going for branch expansion was a lot of hassle and less reliable than picking up wholesale funding in the inter-bank market. That source of funds was quicker, easier and often cheaper than collecting dribs and drabs of cash across the counters.

However, as the Rock remains basically solid, there is every prospect of a take-over battle developing to push the shares back up. Talk of £2 or even £1 a share is just talk and would be robbery as the net asset value was last calculated at £3.97. Certainly I can see a bidding competition pushing prices back towards £4.00 in the next few weeks.

The biggest loser appears to be the Edinburgh-based Ballie Gifford which held seven per cent of the stock in various funds under its management. Not now, however: it has taken a £200 million hit by getting out. It was these sales, with Lloyds TSB not far behind, which contributed strongly to the downward pressure.

This left Scottish Widows Investment Partnership – the investment arm of Lloyds TSB’s insurance subsidiary – still holding 4.7 per cent, or some 19 million shares, but it has also been selling, causing the earlier recovery to be reversed back to an all-time low.

Perhaps Northern Rock should have stayed a building society after all. If so, it wouldn’t be in anything like the mess it is today.

When I first came across the Rock 40-plus years ago, it was a useful little north country-based society. Hence it was often in funds while others were rationing mortgage applications. Remember those days?

Then, mortgage lending was, in effect, a cartel operated by building societies with the rates set by the Building Societies Association. Officially the BSA reflected changes in the Bank of England’s base rate. In practice this tail wagged the dog. Either way, borrowers all paid near identical monthly repayments.

First-time buyer: “How do I stand for a mortgage?” Building Society Manager: “You don’t stand, you grovel!”

That is no joke. I remember one branch manger who used to enjoy giving every young couple we sent over to him a sex talk before agreeing to their application. We had to warn them what to expect.

But one of our smartest moves was buttering up the accountants who held the local NR agency: it meant we occasionally got a loan through when others were still queuing.

Back then, in order to qualify for a mortgage, you would have to open a savings account with your local building society and save regularly for two years or more. Eventually you would go cap in hand to the society manager for an interview. If you were lucky, with a sex lecture thrown in free!

Strict legislation then prevented societies from investing in pretty much anything other than cash and domestic property.

Hence building societies were the key to home ownership in the UK – and became some of the largest and strongest mutual (member-owned) societies in the world.

However, that changed dramatically during the 1980s when Margaret Thatcher introduced new legislation which allowed banks access to domestic mortgage lending. In return, the societies were allowed to provide current accounts, credit cards, personal loans and other products.

The new legislation also allowed societies to seek their members’ approval for conversion into a corporate lender.

The Abbey National Building Society was the first to brave the numerous statutory hurdles – and vocal members’ opposition. Many have since got the Abbey habit so there are now few true building societies left.

Forty years ago, there were 2,700 building societies with the BSA effectively playing a self-regulatory role. If any smaller society was in potential trouble, the BSA would allocate their liabilities to a larger society.

The first news would be an announcement afterwards – there was no panic and just a small two-paragraph news item.

Ironically, in those days, one of the BSA’s sound and reliable ‘white knights’ was the Northern Rock.

Over the years it has absorbed – mostly by mutual agreement as the local building society management basically wanted out – over 200 smaller societies, the majority with a handful of north country-based branches.

But that record was nothing compared with the Halifax – the largest building society in the world, by far – which hoovered up many societies to extend its power-base even further.

Indeed I would not be at all surprised if, when the dust settles, the Halifax acquires the Northern Rock.

Many of the problems facing smaller societies used to stem from an inability to manage their mortgage arrears effectively.

Once the mortgagors were evicted, they had not got a clue what to do. Empty homes deteriorated as losses mounted. But here the Northern Rock is well placed with far fewer arrears cases than many. In this respect the NR management team are one of the best in the business.

It is all very different today. There are hundreds of different mortgage lenders – a mere handful being the remaining building societies – competing in offering over 8,500 different mortgages to choose from – the largest, most sophisticated mortgage market in the world.

There is still a rump of the BSA around but the real voice of the industry is the Council of Mortgage Lenders, although the CML cannot dictate to the Treasury as the BSA used to do.

One question is why the NR hit these troubles when it only relies on wholesale securitisation for approximately 43 per cent of its funding. On average, German mortgage banks use 66 per cent, French and Italian Banks 50 per cent each and Nordic banks 55 per cent, yet nobody is panicking about these continental banks.

Perhaps that is because the European Central Bank has released the equivalent of £150 billion into the inter-bank market to increase liquidity.

The ECB did so discreetly while the Bank of England proudly insisted it would not do the same, preferring to ‘punish publicly’ any bank which required emergency funding. Arguably this was a major policy mistake and the BoE has now agreed to release billions, but it is a little too late.

For years the Northern Rock – the fifth largest mortgage lender (where perhaps I should now add the word ‘formerly’) – has been able to borrow freely in the money markets and funded around three-quarters of its mortgage lending in this way, with only 25 per cent coming from savers. In contrast, Britain’s remaining building societies are presently in a much stronger position than its banks.

Being member-owned, the societies don’t have shareholders and the Building Society Commission (a department of the Treasury) requires building societies to fund at least half of their mortgage lending from depositors.

In fact, the Nationwide – the UK’s fourth-largest mortgage lender and its biggest building society – says it funds 70 per cent of its mortgage lending from savers with only 30 per cent from wholesale sources — largely permanent interest-bearing shares.

With a fixed coupon rate but no set redemption date, these are effectively a tradeable stock.

Thus, the Nationwide is clearly in a much better position to ride out the credit storm than Northern Rock and other banks with a similar funding models. In fact the building society movement as a whole is probably in much better financial shape than the listed banks.