Gold News

A run on the banks?

People queued in Britain today to withdraw their money from a struggling mortgage bank...

ON WEDNESDAY THIS WEEK the UK mortgage bank Northern Rock ran a banner advertisement across the bottom of The Daily Telegraph's front page.

   It promised 6.30% interest on cash deposits, more than 250 basis points above the average rate-of-return offered on time deposits by UK banks in August.

British savers haven't been offered that much money to keep their cash in the bank in nearly a decade.

But Northern Rock's plea for hard cash appears to have failed. On Thursday, it arranged an emergency loan facility from the Bank of England, the UK's central bank. On Friday, queues formed at its branches across the country.

"I am going to take out the lot, every penny," said one anxious saver to Bloomberg as he queued outside the bank's West End branch in central London.

Over in the Square Mile of the City, reports the Financial Times online, a queue formed at the Northern Rock branch just 100 yards from the Bank of England's very own front door.

"The website was down and no-one was answering the phone this morning," said one of Northern Rock's anxious depositors to the FT. "When the shares fell 20% [on Friday morning] I decided to come down and take my money out."

Bereft of both cash deposits and the short-term funds it's been unable to raise in the capital markets, Northern Rock called on the Old Lady to act in its capacity of "lender of last resort". The Bank of England hasn't done this since 1973, back when the collapse of Cedar Holdings – a pioneer of second-mortgage refinancing – threatened to spark a crisis in the country's banking industry.

Northern Rock has also been a true pioneer in UK mortgages. Its sudden trauma also gives the lie – if the lie were still needed – to any claim that America's subprime crisis has been "contained".

The UK's fifth largest mortgage lender, Northern Rock repeated on Friday that only 0.24% of its total assets are exposed to the US subprime market. Ain't no subprime in them thar' home-loans!

Instead, the problem stems from how Northern Rock financed its runaway growth. "In the first 8 months of the year, Northern Rock’s total net lending was up 43% over the same period in 2006, with net residential lending up 55%," as it stated today. This stellar performance compared to its peers came thanks to what the Financial Times now calls "an alternative banking model".

The alternative being that it came from the United States, the home of debt securitization.

"Eschewing customer deposits kept down costs – the bank has just 76 branches – and facilitated a rapid expansion of the loan book," says the FT online. "Compared with the UK banking average of 7%, Northern Rock used wholesale market securitization for 43% of its funding." All told, the UK banking sector held one-fifth of liabilities in securitized loans by April this year, according to the Bank of England.

Back in the United States, meantime, "almost 68% of home mortgage originations were securitized by 2005," says the Federal Deposit Insurance Corporation on its website, and "in the first quarter of 2007, about half of all revolving consumer credit outstanding was held by pools of securitized assets," says Sheila Bair, chair of the FDIC. That matched the pattern of the last 10 years, Bair explained in testimony given before a House of Representatives subcommittee in early June.

If the need to refinance the loan book by appealing to the money markets has undone Northern Rock in the UK, what havoc might the ongoing liquidity crunch be causing in the US banking sector? Outstanding mortgage loans totaled more than $12.7 trillion by the end of last year, according to Plunkett Research. That makes for more than $8.5 trillion in mortgage-backed bonds used to fund America's recent – but now soured – love affair with real estate.

What if the need to raise new finance before extending new loans to buy new homes continues to meet with a big fat "No!" from the money markets?

"Northern Rock is a prime-only lender," as the distressed borrower itself said today, "and credit quality on all its loan books remains strong. Three-months plus arrears in the residential [UK] book were 0.47% at the end of August, still under half the industry average."

But built by borrowing short to lend long – rather than by the old fuddy-duddy method of attracting cash savers and then lending out their deposits – Northern Rock's spectacular growth relied on cheap and plentiful liquidity. That's what the City of London knew. The capital's hacks, on the other hand, did not.

"Buy" said The Times on July 27th. "Buy" said The Telegraph the same day. "I have bought Northern Rock," added an FT journalist one month later, "unable to resist a price of 645p, which gives a forward p/e of 6 and a dividend yield of 6.2%."

The next day, Aug 25th, brought news that private investors were filling their boots with Northern Rock stock, as well. "Last week and the end of the week before were the busiest time we've seen since February/March this year," the FT learnt from Alison Cashmore at TD Waterhouse, the big retail brokerage. Trading volumes increased by more than 50%, she said, with private investors "focusing particularly on banking stocks."

The top five purchases for Britain's private investors in August this year? Four banks and one airline – including both Northern Rock and Barclays, the third largest bank in the UK, whose CEO, Bob Diamond, demanded action from the Bank of England at the start of September.

If you're tempted to buy banking or finance stocks now they've pulled back so sharply, it might be worth asking yourself: What might the capital markets know that you can't as a private investor?

You're left with only last quarter's trading statement for guidance. Just like British share investors who piled into Northern Rock at the end of August.

Adrian Ash

Adrian Ash, BullionVault Gold News

Adrian Ash is director of research at BullionVault, the world-leading physical gold, silver and platinum market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and he has now been researching and writing daily analysis of precious metals and the wider financial markets for over 20 years. A frequent guest on BBC radio and television, Adrian is regularly quoted by the Financial Times, MarketWatch and many other respected news outlets, and his views from inside the bullion market have been sought by the Economist magazine, CNBC, Bloomberg, Germany's Handelsblatt and FAZ, plus Italy's Il Sole 24 Ore.

See the full archive of Adrian Ash articles on GoldNews.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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