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.

Ten Years After the Northern Rock Crisis: and the Economy is in a Worse Condition

We are now ten years away from the date when a still-under-rated minister, Alastair Darling, took the decisive steps that 'rescued' Northern Rock; and, with it, the economy. I referred yesterday to the fact that some five years after the crash a few students in the University of Manchester dared to challenge the fact that their teachers in Economics classes could not explain [within their own intellectual universe] how the crisis happened, precisely what constituted the crisis, and why they had not adjusted their 'analysis' of the economy in the light of a shattering, cataclysmic event. A second set of questions, soon to be posed and left unanswered, was how and why all these clever professors had not seen the disaster approaching.

Off her own bat, the Queen posed the same question on a visit to the London School of Economics, and received no immediate response. A few weeks later a group of professors sent her a totally unsatisfactory sequence of exculpatory piffle, which satisfied no-one. The Queen later put the same question on a visit to the Bank of England; and because they had no answer to the challenge why they had not anticipated the crisis - and thus been able to avert it, or mininise it - they could not give any sort of satisfactory response.

The Econocracy, the Manchester students' term to describe the wrong-headed devotees of free-market Economics, cannot formulate an answer within their terms of reference: I have frequently damned them in this blog, and set them aside again today as being potentially part of a solution to the mess that their dogma created when it was embraced as deep state policy by the Thatcher gang. To anybody who questions the use of the term 'gang' I respond that the tight group of people who advised Mrs Thatcher and her guru Keith Joseph, several of whom were ex-communists, intended their ideologically-driven policies utterly to destroy the mixed economy no less completely than the Bolsheviks had planned to destroy capitalism.

I have perhaps not stated this point strongly enough in this blog so far. It lies at the root cause of the crisis of 2007-9, and thus it still overshadows the British economy, and damns millions of people to diminishing real incomes as they drag out their days on minimum wages in jobs with barely measurable productivity and negative productiveness. Behind the relatively few specific policies that are still recognised as having been 'Thatcherite' [such as selling council houses] there lay a serious ideology which informed the 'deep policy' that lay behind everything that they did. This dogma is the unconditional belief that 'free markets' release the inventiveness of the brightest and best of the rising entrepreneurial cohort: and that their spontaneous actions would give sufficient positive momentum to the economy that hundreds of thousands of redundancies and billions of poundsworth of plant and equipment that were scrapped [or just left underground] could simply be ignored. If you believed this fervently enough, no specific policy and no government investment would be needed to free self-centred components of the economy to expand at an unprecedented rate.

Of course, this ideology comes up against a mass of real-world inhibitions: laws against defrauding or cheating fellow-citizens, laws controlling dangerous substances, the requirements of national defence, the absolute belief of the public that there must be a national health service, the entrenched tradition that children should attend school, and many more. While telecommunications, gas, water and electricity supply were privatised quickly, many areas of the economy could not directly be attacked in the first wave of Thatcherism. Meanwhile the flow of taxation and government spending had to be maintained to keep the publicly-recognised essentials in being; though plans could be made to privatise hospitals and schools; and other public services were required to cut their real cost to the state. The government made a virtue of shutting down the most heavily-invested material industries [where the state had been the prime investor for decades: in some cases for centuries] such as shipbuilding, iron and steel, shipyards and coal mines, regardless of the damage that was done to the economy.

Much of the material economy went into a state of shock, as protections against competing imports were removed and supply chains from foreign countries had to be accessed because British suppliers had disappeared. When the mines and shipyards and steelworks closed, their suppliers were ruined also, and many supply-chain firms failed; which meant that across much of industry there arose   a need to import components that had previously come from the British firms whose major customers had been taken out in accordance with the prevailing ideology.

The one area where buccaneering entrepreneurs could thrive was in banking and finance, where many controls were removed precisely at the time when the emergence of sophisticated computers became available to firms; while the regulators [most notably the Bank of England] did not develop the means to understand what was happening. That was the fruitful field on which the the crisis, to be recognised by ministers in 2007, was developed over twenty years from 1986.

[Next installment tomorrow]

Carney in Jackson Hole

Mark Carney is due soon to return to Canada and make a political career in an environment free of worries about the pound sterling, the European Union and Theresa May. While Trump survives in the US presidency there will be a small risk for Canada in the future of the North American Free Trade Area, but in other respects Trump cannot hurt Canada; and if his failures drive down the value of the US dollar, this will be to the benefit of the Canadian currency and economy. Britain's problems may be of passing interest to Mark Carney post-Bank of England, but he will have [nor will he want] any part in addressing them.

George Osborne is a co-culprit with Cameron and Clegg in most of the disastrous aspects of the Coalition and subsequently the Conservatives' economic policies, but it is generally accepted that he alone drove through the decision to bypass Bank of England insiders, and all other Brits who might have had a claim to be considered as Governor of the Bank of England, and opt to advise the Queen to appoint the clever Canadian. Carney was appointed when the policy of Quantitative Easing and low interest rates had been entrenched by the previous management of the Bank, who had reacted to the meltdown of world banking as a crisis of moral hazard until Chancellor Alastair Darling sounded the alarm and compelled them to act positively [if not entirely sensibly]. Since his appointment, in retrospect, Carney has not had much to do. His 'forward looking' comments about the British economy in context, and what the Bank may or may not do about lending and about interest rates have all been falsified by events; to the extent that some journalists have made a joke of his predictive capabilities. He participated in 'project fear', the campaign to scare the British electorate into voting to remain in the European Union even after the continentals had grossly insulted David Cameron [and, by implication the country that he represented] by their contemptuous dismissal of his half-hearted attempt to make the"ever-closer union" less objectionable to sensible Brits. When the referendum result was announced, before there was time for any deep observation of its short-term impact on the economy and on the currency, Carney led his outfit into panicky and wrong decision to lower interest rates further and to continue 'printing money' that the banks could then lend and drive asset prices [especially house prices] ever higher even as real wages continued to fall.

Mark Carney seems a pleasant man, and has a reputation for high intelligence. His record in Canadian banking is excellent: his record at the Bank of England gains him nul points. Later this week he goes to the US ski resort of Jackson Hole to meet the other governors of central banks, with a massive audience of media, to exchange platitudes. The real meetings of central bankers, that matter, occur in the context of the Bank for International Settlements at Berne; and sometimes the governors have influence when they gather with their countries' finance minister in the context of the G20, G8 [or whatever number gather, dependent on which countries are in favour with the USA]. The annual performance at Jackson Hole, beside allowing opportunity for some private chatter and data swapping, allows some more speculative statements to be made. This year, it is expected that the Chair of the US Federal Reserve Board will indicate the approximate scheduling of future interest rate increases; and that the Chairman of the European Central Bank will indicate that it is his organisation's plan to begin policy tightening, within the next year. Carney will have nothing to say. The Bank of England is still stuck like the proverbial rabbit in the headlights, mesmerised by Brexit, Trump and the fear of Britain being alone in the world without a Churchill able to summon up the Few, the Dunkirk Spirit and the resources that were handed to stand-alone Britain by President F D Roosevelt.

Mr Carney's children have already gone back to their Canadian educational institutes, and he will follow them soon. He has learned a lot, but been unable to do anything. His experience in Britain has fitted him better for his future career in Canada; and Britain gained nothing from his presence with us here.