November 21, 2007

Northern Rock: am I missing something?

Many of the front pages of the front pages of yesterday’s newspapers had the following headline: of yesterday’s newspapers had the following headline:

‘Taxpayers could face a multimillion-pound bill for the rescue of Northern Rock, after Alistair Darling refused to give a guarantee that the £24 billion Bank of England loan will ever be fully repaid.’

But what is the big deal?

Northern Rock had a bank run. This meant they lacked the liquidity to give all their depositors their money back. However this doesn’t mean that they didn’t have the assets. The loans that Northern Rock held are still good. Thus then government lent the bank this money in order to provide them with this liquidity, and then when the loans mature the bank will have the money in order to pay their government loan back. No problem

The only circumstance in which the loan couldn’t be paid back was if there was mass defaulting on loans. This could happen if there was a severe recession in the economy or if there was a severe drop in house prices (thus causing people to have negative equity on their homes). Most economists appear to predict a slowdown in growth in coming years; hence the first scenario won’t happen. In the US average house prices has recently fallen by 8%; thus the second scenario is a possibility.

But surely if there is going to be a massive bursting of the house-price bubble this would make a more interesting headline then noting that the government’s loan won’t be paid back?

Indeed what if this ‘giveaway’? In practice all it really will mean is that a lot of government money is, instead of being spent by the government, is being given to the Northern Rock depositors (i.e. a large group of randomly chosen people) so they can spend it instead.

- 5 comments by 1 or more people Not publicly viewable

  1. As far as I can tell, the money that a bank lends in the form of mortgages or loans etc, is the money that is deposited with it by savers (and current account holders). If the original depositers want their money back then normally a bank would have enough cash on hand to pay these out. If all of the depositers want all of their money back, it would be an unusual bank that would have the cash to pay that out which is why Northern Rock tried to get money from elsewhere, probably by selling some of their mortgages on the money markets (in order to balance their books). However, if Northern Rock has over loaned to people who may be experiencing problems repaying the loans (eg sub-prime) then the loans cannot be traded for their book value and then Northern Rock have to sell more loans to make the difference. If that is the case, then there is a lack of confidence in anything Northern Rock wants to sell in the markets and therefore it will most likely not be able to sell anything anywhere near its proper value. Once this comes out in the open, depositers will want their money before it is all used by the bank in paying other depositers and you get a run. In the meantime, the bank is up the proverbial creek as it has no cash to run the payroll etc and so it becomes vulnerable to people presenting winding up orders in order to get cash out of the bank for unpaid bills for rent, electricity, pensions etc.

    At this point the bank would normally be put into administration or fold and the assets recovered by the liquidator, eg by selling off loans at below market value or by foreclosing the loans ie mass repossessions.

    The bank may have the assets, but it’s cash that it’s short of.

    21 Nov 2007, 15:16

  2. As I mentioned in te meeting today, the emphasis in terms of the government loan is the interest that is (rapidly) accruing on it. The eventual repayment of the loan at it’s face value would not be a problem, though the whether Northern Rock could or even would pay the interest. The bank is arguing that the interest should not have to be paid because the company is such a large employer etc. That is, it would cost the government more to cover job losses etc as a result of Northern Rock going under than it would to allow the bank to default on the interest…

    Or that’s what I think it’s about anyway… it’s all terribly confusing…

    21 Nov 2007, 18:58

  3. Richard.
    I broadly agree with your assessment of the situation. However I don’t think it was the realisation that Northern Rock had bad loans that led them to having to sell their debt for less. Rather it was the financial markets losing confidence in their ability to assess debt that caused them to demand a higher interest rate, as higher uncertainty drove them to demand a higher risk premium.

    This meant that it was a brief loss of confidence by the animal spirits of the financial market that hurt Northern Rock, not that any of their loans were bad. Thus we should expect all the loans to be repaid in the future.

    Suppose people deposited £10 Bn in Northern Rock. The bank then lends this money out. Then it experiences a bank run. It needs a £10 Bn loan from the government in order to give the depositors their money back. In 5 years time the loan has to be paid back, but with interest. However in 5 years time lets suppose all of Northern Rock’s loans come back, plus their interest rate. Thus in 5 years time Northern Rock would have sufficient money to pay back the loan plus the interest rate.

    If however the government’s interest rate was higher then the rate on the bank’s we should expect the bank to be unable to repay it back in full. The problem however is that, as I mentioned above, the new interest rate is higher then before. Hence if the government borrowed the money to give the loan then Northern Rock couldn’t repay it back in full with all the interest. So perhaps the government will end up giving some money to Northern Rock, but this will only be equal to a small fraction of the loan.

    Whether its socially efficient to hence subside the bank to this respect is another matter, personally I think it probably will.

    21 Nov 2007, 20:30

  4. I suspect that this argument about saving Northern Rock employees is being pushed by Northern Rock shareholders as a means to get the government to use taxpayer’s money to bail of those shareholders.

    It’s right to be concerned about the lower paid employees of Northern Rock, they had no part in Northern Rock’s reckless lending behaviour. But anyone holding shares in anything should be aware of the risk of those shares becoming worthless if they allow the top management of their company to behave as if there’s no tomorrow.

    Those at the top of Northern Rock also deserve to suffer financial loss. Only a real possibility of significant personal financial loss will force decision makers to act responsibly in the future. The economist’s term for this is moral hazard

    23 Nov 2007, 10:25

  5. Cal

    all part of the bigger plan. New World Order.

    04 Jan 2008, 22:14

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