Global Credit Crisis on UK Northern Rock

¶ … Global Credit Crisis on UK Northern Rock Bank

The lingering effects of the Great Recession of 2008 still remain, but most authorities appear to agree that the corner has been turned and global economic recovery is well underway. The cause of the Great Recession of '08 was primarily the sub-prime mortgage meltdown that occurred in the United States, and its effects were already being experienced as early as September 2007, when the United Kingdom experienced a mass market run on Northern Rock Bank, the first in the nation's history. The global credit crisis that resulted from these events has been felt in differing degrees by the nations of the world, but few countries in the increasingly globalized international community have been entirely immune from its effects. To gain new insights into this fiasco, this paper provides a corporate profile for Northern Rock Bank, followed by a review of the relevant literature to assess the effect of the global credit crisis. A summary of the research and important findings are presented in the conclusion.

Review and Analysis

Corporate Profile

Northern Rock Bank (hereinafter alternatively "the bank" or "Northern Rock") was incorporated in July 2009 as Gosforth Subsidiary No.1 Limited; this name was subsequently changed to Gosforth Subsidiary No.1 plc a few months later and then to Northern Rock plc by year-end 2009 (Directors' report and financial statements for the period 3 July 2009 to 31 December 2009). These names changes were part of a corporate restructuring process that resulted in part from the global credit crisis. Just a few months following the bank run in September 2007, Northern Rock Bank (hereinafter alternatively "the bank" or "Northern Rock") voluntarily accepted Temporary Public Ownership in February 2008 (Corporate profile 2011). At that time, Northern Rock was faced with a number of challenges that have required a close private-public sector partnership to resolve. For instance, in 2008, Northern Rock's corporate goals included paying back an active mortgage redemption program loan from the UK Government loan; by the end of the year, the bank had succeeded in repaying £18 billion (Corporate profile 2011).

In early 2009, following collaboration with the UK Government in its capacity as shareholder, the bank applied for and received State Aid from the European Commission by late 2009 which allowed Northern Rock to restructure itself into the following two legal entities (both of these entities remain in Temporary Public Ownership):

1. Northern Rock plc. Northern Rock plc is a mortgage and savings bank that makes loans to UK customers through a distribution network of more than 70 branches as well as postal, telephone and Internet operations. The majority of new residential mortgage business is sourced through the UK financial intermediary market. This company is the new savings and mortgage bank that holds and services all pre-existing customer savings accounts and some pre-existing mortgage accounts. The bank is authorized as a deposit taker by the FSA and offers new savings products. It also offers new mortgage lending to support the Government's objective of increasing mortgage supply and sustaining a competitive market. Northern Rock plc holds some wholesale deposits.

2. Northern Rock (Asset Management) plc. This is the former company that was renamed, and which now holds and services the balance of the pre-existing residential mortgage book and is regulated as a mortgage provider by the FSA. It is not a deposit taking bank. 90% of the mortgages held by Northern Rock (Asset Management) are fully performing and are not in arrears, and this company would not, therefore, be accurately described as a 'bad' bank. The portfolio includes the Company's interest in those mortgages allocated to the Granite securitization and covered bond programs. It does not offer any new mortgage lending (Corporate profile 2011). This entity also assumed responsibility for administering the bank's unsecured loan accounts, as well as the UK Government loan and the former Northern Rock's pre-existing wholesale funding and subordinated debt instruments (Corporate profile 2011).

The revised corporate new structure became effective as of January 1, 2010 and was designed to help eventually return the bank to private ownership (Corporate profile 2011). In addition, the bank has provided for ongoing support of its independent charity, the Northern Rock Foundation (Corporate profile 2011). The bank's current core businesses are described further in Table 1 below.

Table 1

Northern Rock Bank's Core Businesses

Business

Description

Retail Savings

The Company has a savings promise in place for its retail savings customers. Northern Rock plc will give its savers two months' notice of any reduction in interest rates, and where the notice on an account is greater than two months' will provide the equivalent notice period. Northern Rock plc will write to its savers at least once a year with details of all its variable rate savings accounts, including interest rates payable. Northern Rock will give its savers two months' notice of any changes to the Terms & Conditions of their account(s).

Residential Mortgage Lending

Residential lending represents Northern Rock plc's core activity.

Northern Rock plc's residential mortgage assets are spread geographically throughout the UK.

Insurance Products

Northern Rock distributes a limited range of household insurance products primarily to residential mortgage customers, via third party providers. Life assurance products are supplied to Northern Rock plc's customers through a relationship with Legal & General.

Source: Corporate profile 2011, pp. 3-3

The key highlights from the bank's most recent half-year results include the following:

1. Northern Rock has continued to build momentum during the first half of the year and considerably improved its position over 2010;

2. The underlying loss1 of £78.8 million in the first six months of 2011 was in line with expectations and significantly reduced compared with the loss of £140.0 million in the first half of 2010;

3. The bank currently expects to begin trading profitably during the second half of 2012;

4. The bank continues to prepare for a return to private ownership and to explore the option of a sale of Northern Rock

Of the bank's progress in recovering from its former doldrums, Northern Rock Bank's executive chairman, Ron Sandler, observed that although the bank is still losing money, this was expected and significant progress is being made in reversing these trends with substantial recovery anticipated by late next year. In this regard, Sander emphasized that, "Northern Rock has made good progress in the first half of 2011. The [bank] continued to be loss-making, as expected, but losses are significantly reduced and we are generating momentum. The [bank] expects to begin trading profitably during the second half of 2012" (Northern Rock first half year results 2011).

The bank's executive chairman added that although firm planning continues to be made by the bank for its future success, the handwriting on the wall suggests that even more aggressive planning is being made for its eventual sale (Northern Rock first half year results 2011). For example, according to Sander, "We are working closely to explore the options for a sale of Northern Rock, at the right time and in the best interests of taxpayers. We are pleased with the level of interest we have received, and will continue to explore the sale option over the coming months. In the meantime, it is business as usual" (Northern Rock first half year results 2011, p. 3).

As a result of the corporate restructuring that became effective January 1, 2010, across the board comparison of the bank's historical performance are not possible. According to the bank, "This is the first set of results for the Company following the operational separation of Northern Rock from Northern Rock (Asset Management) plc in late 2010. Prior to this, the accounts included both income and costs relating to a broad set of operational services provided to NRAM, which has a distorting effect on some comparisons" (Northern Rock first half year results 2011, p. 3).

Notwithstanding these limitations, it is possible to discern the effect of the global credit crisis on the banks based on its reported performance since that time, including the following highlights from its latest corporate filing as set forth in Table 2 below:

Table 2

Recapitulation of recent Northern Rock financial performance

Category

Description

Losses

1. The bank reported a loss for the first six months of 2011; however, this loss was substantially smaller compared to the same period for 2010;

2. The statutory loss was £68.5 million (six months to 30 June 2010 - £142.6 million);

3. The underlying loss, excluding hedge accounting volatility, was £78.8 million (six months to 30 June 2010 - £140.0 million).

Funding

1. Northern Rock is a predominantly retail funded bank, with retail deposits representing 93% of total funding;

2. Deposit balances are in excess of mortgage balances;

3. Retail deposits have been actively managed as the bank continues to focus on improving funding margin. Retail balances were £17.0 billion at 30 June 2011, compared with £16.7 billion at 31 December 2010

Income

1. Total income was £40.6 million in the first half of 2011, compared with £28.5 million in the first half of 2010;

2. This included net interest income of £29.8 million, compared with negative net interest income of £48.4 million in the first half of 2010;

3. Other income fell compared with 2010, primarily as a result of the reduction in fee income from NRAM following the separation of the two companies -- this is partially offset by a reduction in the cost base.

Lending and credit quality

1. Gross lending (including retention business) was £1.5 billion in the six months to 30 June 2011 (six months to 30 June 2010 -- £2.0 billion), while net lending was £0.3 billion in the same period (six months to 30 June 2010 -- £0.9 billion);

2. The lending profile has been managed for value, and this resulted in a reduction in completions in the first half compared with the same period in 2010;

3. The quality of lending remains high, with mortgage accounts more than three months in arrears at 30 June 2011 representing 0.26% of the book;

4. The average loan to value (LTV) for new lending completed in the first half was 69% (six months to 30 June 2010 -- 60%) and the average indexed LTV of the book was 61% at 30 June 2011 (31 December 2010 -- 59%).

Operating Expenses

1. Operating expenses in the first half of 2011 were £106.8 million, compared with £170.7 million in the first half of 2010, including exceptional costs of £11.6 million (six months to 30 June 2010 -- £32.4 million)

2. Liquid assets represented 34.9% of total assets at 30 June 2011 (31 December 2010 -- 31.7%).

3. The bank expects to be loss-making for the full year 2011, but with a significantly improved position over 2010;

4. The bank currently expects to begin trading profitably during the second half of 2012

Source: Northern Rock plc: Half Year Results 2011

Assessment

In the recent past, the bank had clearly demonstrated the ability to respond to a dynamic marketplace in ways that could help it weather a global credit crisis. For instance, according to Watkins, "Northern Rock, attracted over 100,000 customers within eighteen months of setting up a personal banking service which offers an interest-paying current account option" (1999, p. 34). Just prior to the onset of the Great Recession of 2008, though, the bank was clearly in trouble. In this regard, Weale (2007) suggests that the initial effects of the sub-prime meltdown in the United States could already be felt in the UK. In fact, in September 2007, the United Kingdom experienced its first mass market bank run and while there had been bank runs during the 19th century, the number of people who actually had bank accounts was miniscule so these events were dwarfed by the Northern Rock experience with respect to a failure of mass retail banking (Weale, 2007).

Most authorities agree that the global credit crisis was spawned by the sub-prime mortgage meltdown that took place in the United States. For instance, Weale reports that, "Sub-prime mortgages, like other mortgages, were converted into traded securities with complex structures. European banks bought these securities in the belief that they were diversifying their portfolios but without any real understanding of the risks that they were running" (34). The actual beginnings of the global credit crisis have been traced to fateful announcement by the world's largest bank, BNP Paribas, on August 9, 2007 that it would be unable to value some of its mortgage-related securities and a ripple effect was felt throughout the banking and financial services industries (Weale 2007).