Lessons of the Fall

How a financial darling fell from grace, and why regulators didn't catch it.

A month after Northern Rock made shocking headlines around the world, the full story of Britain’s first bank run in 140 years has yet to be told. People were little the wiser this week, after Adam Applegarth, the mortgage bank’s chief executive, and Matt Ridley, its chairman, tried to convince a sceptical parliamentary committee investigating the fiasco that they had been struck down by a bolt from the blue. The business model of Britain’s fastest-growing mortgage bank — which funded its loan book mainly from the wholesale markets, rather than from retail deposits — had been prudence itself, they explained, derailed only by sloppy lending in America that caused those markets to seize up in August.

But their Northern Rock is now a busted flush. None of the three groups who talk of buying it at a knock-down price — a consortium led by Sir Richard Branson’s Virgin Group and two private-equity outfits, Cerberus and J.C. Flowers — wants to keep its name. The bank, kept afloat at present by £13 billion ($26 billion) of public money, does not rule out going back to the Bank of England for more. And just as Northern Rock’s bosses deny imprudence, so the central bank’s governor, the head of the Financial Services Authority and the chancellor of the exchequer stoutly maintain that they were not responsible for the mess either.

Yet the story needs to be pieced together, for the debacle has had three important and unpleasant consequences. A financial institution that underpinned for years the economy and self-image of one of England’s poorest regions, the northeast, has been destroyed. The reputation of a broadly good central-bank governor has been tarnished. And an admired regulatory system that helped to make London the world’s biggest international financial center has fallen into disrepute. What went wrong? What signals were missed? And what lessons should bankers and regulators both learn?

The faster they come

The year that Northern Rock fell from grace could hardly have started more promisingly. In January the bank announced record pre-tax profits of £627m for 2006, 27% higher than the previous year’s. This marked a decade of success since its conversion in 1997 from a building society—a residential mortgage lender owned by its savers and borrowers—into a bank quoted on the stockmarket. Year after year its assets had grown by a fifth, even though it had few branches — 128 when it converted and 76 this year. A small local lender had become Britain’s fifth-biggest mortgage provider, ambitious to become its third-biggest before long.

The trick Northern Rock pulled off was to rely on wholesale markets rather than on retail deposits to finance most of its lending. More than any other big British lender, it relied on “securitizing” its mortgages. The bank bundled its loans together and packaged them into bonds that it sold to investors around the world. In January 2007 it raised £6.1 billion that way; a second securitization in May brought the first-half total to £10.7 billion and made Northern Rock the top securitizer among British banks. With money swirling around the world’s capital markets, securitization worked a treat. By tapping global wholesale markets, Northern Rock was able to raise money more cheaply than its home-bound rivals, price its mortgage offers more keenly and carry on its hectic expansion.

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