Northern Rock: How the Crisis Happened

Northern Rock was the first bank in the UK to go bust for almost a century and a half; thus it was a great shock, which the authorities were not prepared for. I commented yesterday how Alastair Darling, the Chancellor, rose to the occasion ad accepted responsibility for finding a way of resolving the crisis and ensuring that the depositors got their money back.

There was no mystery about how the crisis happened. A few months earlier, in a lecture to the Insurance Institute of Ireland, I warned that the banking system was heading for a catastrophe. I said specifically that insurance companies should avoid accepting any bankers' risk onto their own balance sheets: if they did, they would be brought down with the crashing banks. Only one insurance giant, AEG, took on a massive amount of bankers' debt. Hardly recognised by their US head office, a minor London market component of the massive global conglomerate accepted billions of dollarsworth of a clever new 'financial instrument' that would only be activated in the most exceptional circumstances: then they would have to pay in full on those certificates. Hence, later in the crisis period, the US Treasury had to take over AEG and meet obligations of hundreds of billions of dollars. The existence of those obligations had not been understood by the firm's central management nor by any of their regulators while these liabilities were adopted.

The much smaller-scale, but still catastrophic, crisis that affected Northern Rock in September, 2007, arose from the same cause as the crises that hit bigger institutions in subsequent months. Thus it stands as a perfect example of the consequences of the Thatcher government releasing new 'market forces' into financial services. Until the nineteen-nineties Northern Rock was a Building Society, largely serving customers in and around Newcastle Upon Tyne. But in the mood of market freedom that followed the 'big bang' of 1986, 'the Rock' was transformed into a bank and it expanded its operations nationally. It could do this because the executives had realised that they no longer needed to accumulate new 'capital' slowly. There was a new 'wholesale market' of firms anxious to build their business by giving access to large amounts of credit to building societies. Ambitious managers throughout the country were changing comfortable businesses [which took in their assets as peoples' savings, and lent them to reliable wage-earners as mortgages] into aggressive, competitive lending machines. Licensed lending firms could sell mortgages to people who promised to repay over many years; but the new twist was that the lender could then bundle these contracts up into multi-million-pound 'packages' and sell them to the new 'wholesalers'. In return for millions of pounds a year of income [to be paid by the mortgagees], the wholesalers bought these bundles. Thus the ex-building society had more millions to lend to more customers, which became mortgage debts that the seller then bundled into new packages and sold into the wholesale market. This enabled the mortgage lenders to compete more aggressively for business. Northern Rock became famous [a fame later converted to infamy] for its willingness to lend more than the asking-price of the house that a customer wanted to buy: so that, in addition to getting a 100% mortgage there was a cash sum to pay for furniture. Furthermore, customers were not asked to prove what they said was their income: 'self-certification' was the polite term: 'liar loans' was often a truer description.

The banks joined in this competition. Most retail banks had always done some mortgage business; so they, too packaged parcels of promises-to-pay by mortgage holders and sold them in the wholesale market. What they sold was the promise of a cash flow into the future, embedded in a contract known as a security. Hence, the process came to be known as securitisation and all the people who used it both from the 'retail' market of mortgages and credit card debts and from the 'wholesale' side of the business that swapped credit for securities passed on the securities to other innovative firms.

The old style building societies had obligations to their depositors, and assets in the form of the cash balances that they held plus the valuation of the mortgaged properties. Their assets exceeded their liabilities, in general; and they had the added security that the [usually inflated] price of a house whose mortgagee failed to maintain payments meant that when the house was sold, the price would usually pay off the mortgage debt and the accrued arrears of interest. In the new world of securitisation, Northern Rock had also bought some of the packaged securities as part of their capital reserve. So when the word went around that the Rock was insolvent, and queues of depositors gathered at the doors of their branches, the firm did not have ready money to pay them. This caused a widespread market panic over the solidity and security of a vast range of securities, which may include some mortgages. There had already been a panic in the USA over the similar packages including 'sub-prime' mortgages, which made the British market more insecure. In order that the Northern Rock customers could get their money, the Chancellor ordered the Bank of England to make the cash available.

Over subsequent years, as the mortgages were repaid, it became clear that Northern Rock's assets had exceeded its liabilities as of 13 September 2007; but they had not been able to turn their assets into cash at the moment the depositors demanded it. Hence the crisis has rightly been called a liquidity crisis. Over the next ten years it became apparent that most of the clever 'products' that were floating around the wholesale market were basically sound: but as the financial crisis developed over 2007-8 those securities could not be liquidated: that is to say, swapped for cash on demand. Hence Quantitative Easing, QE, was needed; and more of that anon.

The Tragic Triumph of the Econocracy

'The Bank', with a capital letter, means the Central Bank in any country or community: in our case, the Bank of England; and 'the banks', as a collective, means all the other firms and partnerships that the Bank recognises as legitimate banks and thus it is authorised to give them instructions and to trade with them. Specifically, it will sell them bonds and other debt certificates [from a list of approved categories] and lend them money at a publicly announced rate of interest called 'base rate'. A large proportion of the Econocracy [the prevailing rat-pack of professors of Economics] argue that if the management of the banks by the Bank is perfectly calibrated the economy can operate perfectly. If the money-managing institutions work perfectly, the whole economy can achieve 'equilibrium': a state where all the resources available to the human race are allocated to their optimum uses.

This is a model of perfection. The realities of human existence make it a total nonsense: but the Econocracy currently has control of the channels of advice to governments, and most of the economic commentators in the media, in banks and investing institutions are required to parrot the prevailing orthodoxy: though there have always been some brave spirits who have the wit and the integrity to deny the validity of the whole structure.

So-called Monetarism, a package of ideas formulated by Econocrats in terms that could be explained to politicians and to students, was introduced in the USA in the later nineteen sixties, when the flaws in the attempt at practical neo-Keynesianism had generated a disastrous wage-price spiral as trade unions demanded pay increases to match price increases [as reported on official indexes of 'inflation']. In the early nineteen seventies the major oil-exporting countries tripled the royalties that they charged for access to their oil and natural gas; and this sent up the prices of all goods and services because of the universal impact of the costs of fuel for vehicles to deliver goods and people to where they were wanted, and the price of fuel for the provision of energy to heat homes and schools and to power factories. Additionally, petroleum was a vital ingredient in many plastics and polymers. So all prices were rising, hence wage demands took on a new stridency: and governments tried to stop the 'spiral' going out of control.

The Monetarists argued that if real control was given to the Bank and the government backed up the Bank in issuing stringent instructions to banks as to when and on when terms they could lend money to whom, that would strangle the spiral of rising wages and prices. Employers would not be able to borrow from their banks on affordable terms: so instead of borrowing to pay workers inflated wages, they would have to tell them "take what is on offer, or we'll have to close down and sack you all". Similarly, consumers would be told that they could only stay in the homes on which they were servicing mortgages provided they paid penal interest rates which went as high as 15%: which left them with little to spend on other things. So if they kept the house and the car, paying high mortgage interest and high interest on their car loans and the loans against which they had bought their fridges and TV sets, they had to reduce consumption of everything else.

The Thatcher government adopted their own version of this policy straight after their election in 1979, and by 1992 they were well on the way to implementing it. Economic growth slowed dramatically; and wage growth slowed even more. Then the government itself stopped creating money with which to maintain activity in the coal mines and the shipyards. They compensated for the loss of income that they suffered as the real economy declined from the tax revenue that they received on North Sea oil and by the sale of the privatised industries. They cut back heavily on government spending on defence and in support of industries that had previously been considered essential for national survival: steel, shipbuilding, aerospace and coal. The economy was dramatically changed, as the 'real' material productive sectors were decimated and the financial services - notably 'investment banking' - began to predominate: and that sector of the economy was supposedly susceptible to refined control by the Bank.

Thus, by 2005 the 'real' - the material - economy on which human animals depend for their continued existence and comfort was utterly denigrated and largely despoiled; and the finance sector was put in a position to undermine the entire economy through its greedy overindulgence in speculative deals that the Bank did not even understand. This is the achievement of the Econocracy. The real incomes [money wages adjusted so that their current purchasing-power can be computed] of the mass of the British population have been static for a decade. Over those years, 2007-2017, plenty of jobs have been created; almost all of them in activities that do not result in any substantive increment to the real economy. There has been a spectacular degree of material stagnation which, set alongside the government's obsession with 'austerity' [in which they have been mentored by the same Econocrats] leaves almost everyone with an awareness that the economy is not "working for me". That is because the economy is being driven in obedience to an abstract model. The fundamental reality, that the economy should be the mechanism that serves material, living, aspirational individuals, has no place in contemporary Economics. That is why Economics must be brought down from its high place in academic temples, and opened up for radical restructuring.

Guff at the G20

Some of the people who are regarded as the most important 'leaders' and office-holders in the world have been to the seaside in Mexico with the ostensible purpose of stabilising the global economy. The slow-motion unwinding of the eurozone has been extended by the emergent powers placing additional credit with the International Monetary Fund so that it will be available to be pumped into Europe: conditions will be specified but it is most unlikely that these would be so draconian that they would ensure that the euro collapses. Low-grade politicians who hold on to power by default in countries outside the eurozone have again admonished those inside the common currency to get their act together; once more these focus on trying to bully Germany into dissipating its savings on helping other eurozone countries. So far, Germany has declined to obey, and the President of the EU Commission has blamed 'North America' for the crisis.

My analysis firmly locates the origin of the global financial crisis in London, England. With the 'big bang' of 1986.the Thatcher government smashed the traditional division of financial transactions in the City of London between stock brokers and jobbers, banks and merchant banks, separate exchanges for different types of transaction, self-regulation within each sector and ultimate oversight from the Bank of England [which preferred to steer market members into approved ways of working by winks and nods and secret meetings]. The phrase big bang had become central to theoretical physics, to describe the moment immediately after the creation of the universe when its great expansion and diversification began. By applying that phrase to the finance sector enthusiastic commentators implied that here was a new beginning in a newly structured market that could grow immeasurably and bring great profit to the participants: who could then be taxed to meet some of the growing deficit on government income as industry was destroyed while farming and fisheries were left to wallow under heavily protectionist EU regulations. The rapidly advancing capabilities of computers enabled the markets to be operated at speeds and with complexity far beyond the former trading patterns that had depended on word-of-mouth and typewriters. New types of 'product' - most obviously derivatives and new processes for securitisation - burgeoned on an almost astronomical scale, and old contract types such as futures were reformatted and used in vastly different new ways. The world's banks brought business to London and Wall Street looked set to lose the dominance of global markets that it had gained in the nineteen-thirties and consolidated through the Second World War, Marshall Aid and Cold War. Ferocious lobbying of the politicians in Washington led to the repeal of legislation that had mandated the separation of 'retail' and 'wholesale' banking,  and had differentiated banking from broking; with the specific intention of enabling Wall Street to compete with the City of London. Small differences in regulations led globalised businesses to put some business in New York, some in London and a little in other centres such as Hong Kong and Singapore.

Thus far the London big bang was the origin for the new pattern of trade; but then the US government decided to tap into the markets in the interests of social engineering. Given that such huge and flexible financial markets existed, surely they could be required to lend money to people who sat at the bottom of the heap in society. Let even the poorest become home-owners and thus gain some pride of possession and learn to earn the money necessary to service their mortgages and care for their homes. Mortgage lenders were required to allocate some of their funds to 'sub-prime' mortgage borrowers: two government-backed institutions underpinned the mortgage market, but the wholesale market practitioners became increasingly keen to securitise 'bundles' of mortgages and re-sell the securities into the general financial markets. After a very few years just about every bank and securities manager included some sub-prime mortgages buried within their so-called 'assets'. Once it was demonstrated that hundreds of thousands of feckless Americans were not paying their mortgage debts or maintaining their houses well, it was clear that some portion of the 'value' of many hundreds of thousands of 'assets' was non-existent. Thus the trigger for the crisis was squeezed in North America, but financial institutions from all over the world were deep in the mess and the resultant reckoning is ongoing. American sub-prime lending was the mechanism for the disaster; but its origin lay in the reckless gamble by the Thatcher government.