Magazine article Public Finance

Collateral Damage

Magazine article Public Finance

Collateral Damage

Article excerpt

Whatever happens in the forthcoming Comprehensive Spending Review, the public sector has reasons to be very, very appreciative of Chancellor Alistair Darling. He has saved them from millions of pounds in losses.

Had Northern Rock collapsed - which looked likely - local authorities would have lost heavily. Local government in London alone had more than £50m on deposit with the stricken bank

The Bank of England's intervention - giving Northern Rock access to a reported £8bn in emergency loans - followed by the chancellor guaranteeing the bank's deposits, did more than provide reassurance to the financial system. It was excellent news for institutions as well as individuals with accounts at the bank. Public sector pension hinds have not been so fortunate some have lost from the bank's collapsed share price and, to a lesser extent, falls in other banks' share prices.

The Northern Rock affair is a very modern financial crisis. Its cause is an interweaving of the impact of globalisation, the use of extremely complex 'financial engineering' and old-fashioned ambition on the part of the bank.

Northern Rock's origins are in the nineteenth century as two local building societies in the Northeast of England. The Northern and Rock societies merged in 1965 and took over another 51 societies. But the society's executive team had ambitious plans, involving its conversion to a PLC a decade ago. As its directors boasted to an all-party parliamentary committee, their subsequent expansion was possible only because of demutualisation.

While most mortgage lenders finance loans from deposits, Northern Rock wanted to expand fast. So it borrowed heavily on the international market for funds to put into UK home loans. But when international loans dried up after heavy defaults in the US's 'sub-prime' sector - loans to borrowers on low and doubtful incomes - the bank could not finance its immediate liabilities.

Instead, it had to go to the Bank of England for emergency funds. The Financial Services Authority issued assurances that Northern Rock's underlying solvency was not in doubt. But that could change, as the bank has other problems. It issues mortgages on the highest loan-to-income ratio of any lender (5.9 times income) and equal highest loan-to-value (up to 125% of home value). This helped stimulate the house price boom and makes the bank vulnerable if prices fall. Now Northern Rock earns a lower rate of interest on home loans than it pays to the Bank of England, or is available on the international market

Other banks suffered too from the financial crisis, with falling share prices. Two German banks had to be rescued; the largest US mortgage lender, Countrywide, is in difficulty and the second largest sub-prime lender in the US, New Century Financial, is in bankruptcy protection. Two hedge funds have gone bust

But other hedge funds have done well. (The term 'hedge fund' covers a variety of alternative investment strategies - only a small proportion back US sub-prime loans.) Several funds have made massive profits by 'short-selling' Northern Rock shares - 'renting' them from institutions, selling at high prices and buying back after the share prices fell.

These profits came at the expense of the bank's shareholders and would probably have been at depositors' too, but for the government's guarantee. The Metropolitan Police Authority, the London Fire Authority and the Greater London Authority each had several million pounds in Northern Rock deposit accounts.

A spokesman for the MPA told Public Finance last week: 'The MPA currently has £39m invested in Northern Rock, £29m of which matures this month [September], the remaining £10m in November. This is 12% of the total monies invested by the MPA in various financial institutions'

A GLA spokeswoman says that it had £5m on deposit at the bank, which represents only a small proportion of funds' currently invested. She adds: 'Our deposit with Northern Rock was made on Wednesday, September 12, before any hint that it might have serious liquidity problems and before its credit rating was first reduced on the Friday, at which point it would not have met our criteria for lending and therefore no further loans would have been made. …

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