SAY IT AIN'T SO, MERVYN!

Dear Governor King,
On Wednesday 12 September, YES, ONLY TWO DAYS AGO, you wrote to Parliament, quote:
“The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.”

You went on to confirm that whilst the Bank would lend overnight at penal rates to needy banks, its interventions would not venture further down the yield curve for longer maturities. In addition, the Bank would only accept risk-free collateral (i.e. government securities) from borrowing banks.

Last night, you, Chancellor Darling and FSA Chairman Sir Callum McCarthy, turned 180 degrees and bailed out Northern Rock, one of the prime engines (and now self-inflected victim) in the UK of the CDO debacle, for an indefinite amount for an indefinite period and collateralised by mortgages!! And what was the basis for this u-turn, none other than the argument by the FSA that Northern Rock “is solvent, exceeds its regulatory capital requirement and has a good quality loan book.''

Let’s just take these points one by one, shall we?

IS SOLVENT
Rather than start off by tossing the words of your own regulations back in your teeth, let’s just use the definition of Solvency as given by the Reserve Bank of Australia:
“… it is the capacity of an entity to meet its financial obligations as they fall due. Solvency may be expressed as maintaining positive net-tangible assets ... in short, having sufficient cash and cash sources at times when long-term obligations and claims become due.”

But what does this mean in practice? Simply, that a bank’s solvency depends on its ability to retain the confidence of both its depositors and the financial markets or institutions on which it may rely for funding.

The fact that Northern Rock had to turn to the BofE to fund its liabilities, because it could not raise sufficient funds under its own power in the public markets either from depositors or other institutions, means that it is insolvent.

EXCEEDS ITS REGULATORY CAPITAL REQUIREMENT
According to the Lex Column of today’s Financial Times, “based on its current market capitalisation (Northern Rock) barely exceeds core tier one capital.”

For those of you who are wondering, tier one capital is a term used to describe the capital adequacy of a bank. Tier-one capital is core capital, this includes equity capital and disclosed reserves. Equity capital includes instruments that can't be redeemed at the option of the holder.

At present, until the full introduction of the Basel II capital reforms, the FSA requires a bank’s tier-one capital to be no less than 8% of the entities risk weighted assets. The combined ratio of tier-one capital and tier-two capital (Tier-two capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt.)

To fall below this level of gearing (equity to liabilities) while not desirable is usually not a major problem because of what makes up the normal liabilities of a UK bank’s balance sheet.

Major UK banks’ aggregate balance sheet at end-2006

Sources: Bank of England, FSA regulatory returns, published accounts & calculations.
(a) Includes borrowing from major UK banks.
(b) Includes (among other items) loans to UK-resident banks and other financial corporations and holdings of UK government debt.
(c) Includes Tier 2 capital, short positions, insurance liabilities and derivative contracts with negative marked-to-market value.
(d) These assets are not risk weighted. As a percentage of risk-weighted assets, Tier 1 capital is 8%.

At present, until the full introduction of the Basel II capital reforms, the FSA requires a bank’s tier-one capital to be no less than 8% of the entities risk weighted assets. The combined ratio of tier-one capital and tier-two capital (Tier-two capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt.) To fall below this level of gearing (equity to liabilities) while not desirable is usually not a major problem because of what makes up the normal liabilities of a UK bank’s balance sheet.

Northern Rock's Aggregate Balance Sheet at End-2006

Unfortunately, as you can see, Northern Rock looks nothing like the “average” UK Bank, with only 76 branches supporting its £100+ billion balance sheet. The “key” to their success, as well as their downfall, is their funding base – euphemistically described as “debt securities” - actually securtisations and covered bonds sold into CDOs. The problem is that the bottom has fallen out of the securitisation and CDO market. Thus Northern Rock has had to fall back on the inter-bank market for its funding, most importantly, the renewal of their short-term borrowings. A month ago, Northern Rock was offering flexible fixed-rate mortgages at an annual rate as low as 6.19 percent, according to a press release on its Web site. Since then, the rate financial institutions pay to borrow for three months has climbed to 6.82 percent from 6.28 percent. Add to this that Northern Rock net lending surged 43 percent in the first eight months of the year and you have the makings of today’s disaster.


HAS A GOOD QUALITY BOOK
In fairness, this remains to be seen but at the rate of growth that Northern Rock has sustained over the last several years there is a natural concern as to the quality of their existing book. One thing is for sure, the mortgages that they have put up as collateral to the Bank of England can scarcely be considered equal to UK gilts.

I think it fair to say that on all counts, the argument for rescue is spurious and goes against the very heart of the policy you, Mr. King, announced two days ago.


SO WHY AM I BEING SO HARD ON NORTHERN ROCK?
Because they have earned it! They have been the poster-child for the new and improved, risk-shedding, profit-making financial institution.

Starting from its origins as a modest Newcastle based building society, it has become a financial institution which borrows literally from the world and has thus been able to grow its mortgage book by 20% per annum over the last 3 years.

Last year alone they sold £17 billion in mortgage backed bonds and to date 47% of its mortgage business has been securitized, compared to the UK average of 7%. What makes this all the more ironic is that this scale of activity was made possible in part because the regulator – the FSA - reduce the reserves of cash that an institution needs to hold against loans that they securitise.

So successful was Northern Rock in the use of this “strategy” that were named in January as the "best financial borrower" for 2006 - meaning, most creative in raising funds. That’s right not some bulge-bracket Wall Street or City name but an erstwhile mortgage bank that figured out an end-run around risk.

Did I say an end-run around risk? Well, at least they thought so. After all, the logic is that they benefit because once mortgage-backed bonds are sold, somebody else is sharing the risk. Thus, in the event of a housing crash, a lot of the pain is suffered elsewhere. One wonders if the buyers of these mortgage-backs realize the danger that exists in the rapid lending and churning process. The sheer velocity of turnover calls into question how seriously or how well the original lender, who no longer bears all the burden of the risk for bad lending, takes the credit review process. There is a real risk that such lenders become less driven by concerns about the quality of the debt taken on and more driven by keeping the engine stoked.


SO, WHERE DOES THIS LEAVE US?
Regrettably, it leaves us being led by men like you, men with feet of clay. If the strength of conviction of The Great Troika - you Mervyn King, Alastair Darling and Callum McCarthy - could not last 48 hours, what hope is there that you will be believed again any time soon? You and your colleagues had the opportunity to walk the walk as well as to talk the talk and you failed. You allowed fear of market turmoil weaken your resolve; you let fear dull your wits as you failed to think through the problem carefully. Why did you not work on a plan that would have supported the depositors whilst taking the ball out of the hands of incompetent executives and place it in steady, firmer hands? Surely, if you had the presence of mind you could have pulled together a rescue within days rather than issue a carte blanche to the very people you upbraided only days before. When you said that quick bailouts would threaten “the efficient pricing of risk by providing ex-post insurance for risky behaviour. That encourages excessive risk-taking and sows the seeds of a future financial crisis” did you mean it? Were your words, just that, only words, empty promises to placate the masses and show yourself a "leader" until you were actually called on to be one?

Quo Usque Tandem Abutere, Mervyn, Patientia Nostra?

EPILOGUE
Some 230 years ago, with their backs against the wall, the future of their cause not just uncertain, but almost lost, the hearts and spirits of a ragged band of revolutionaries were lifted by these words:

These are the times that try men's souls.
The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of their country; but he that stands now, deserves the love and thanks of man and woman. Tyranny, like hell, is not easily conquered; yet we have this consolation with us, that the harder the conflict, the more glorious the triumph.

These words galvanised that dwindling army; two days later it crossed the Delaware took Trenton & Princeton and set its feet on the road to victory.

Words do matter, but only when they are coupled with action.

Why, when we need a Churchill, are we given a Chamberlain?

O Tempora! O Mores!


Cassandra