Northern Rock

Isolating what caused the 1929 crash is something that still keeps the academics in generous grants, but what it did expose was the seismic impact on financial markets of human emotion. When everyone is selling, you don’t wait to find out why they are selling, you sell too. As do sheep, who all start running in the same direction at the suggestion of a spry collie dog, so too humans. Sell, sell, sell. And it’s not just stocks. Some four thousand banks went belly up in the Great Depression unable to meet their obligations.

Banks historically have made money by taking deposits, and then lending those deposits out in the form of loans. They would pay interest on the deposit, incentivizing customers to leave their money with them, and then loan out the deposit at a slightly higher rate to anyone who wanted it. The difference would pay for the bank manager’s lunch. The problem for the banks, at times of blind panic, is that they only keep a couple of suitcases full of cash in their vaults. If all their customers decide to pop in one morning and ask for their money back, they don’t have it. That’s when they have to close the doors and tell security not to let anyone in. Word gets around town and before anyone has finished their morning four-ball, you have a bank run. If you get lots of bank runs at the same time, you get a systemic banking crisis quickly followed by a long economic recession. Crumbs.

In the UK the last bank run was in 2007 when customers of the slapdash building society, Northern Rock, got wind the bank was running out of cash and all started queuing up to get their money back. The media went into meltdown. The CEO, caught with his trousers around his ankles looking all a bit sheepish, said, “The world stopped on August 9th.it’s been astonishing, gob smacking. Look across the full range of financial products, across the full geography of the world, the entire system has frozen.” Well, sort of the world, sort of the Northern Rock business model.

Northern Rock was once a sleepy building society in the north of England. It was formed from the merger of three building societies, who then spend three decades buying more building societies. A benign economic backdrop encouraged an easing of the sails, and like many building societies in the 1990s fell to the silver-tongued charm of the city and floated on the stock market. The members felt betrayed. The management eyed a bigger car and a new kitchen.

The business model of the new, buccaneering Northern Rock came straight out the US. Once a steady, dour faced Northern lender, the bank became a mortgage hot house which grew at breakneck speed to become the UK’s fifth largest mortgage lender. Rather than using deposits, the bank would borrow money in the market from other banks and institutions, and then lend that money out as competitively priced mortgages. They would then, bundle up all these mortgages and sell them to other people who were interested in buying the perceived steady income stream of lots and lots of mortgages. This was called securitization and they then did it again, and again, and again. The bank was thus able to grow its lending book without having to pull in deposits. Profits exploded.

Then it all went wrong.

Funding dried up. Demand for securitized mortgages disappeared and Northern Rock found itself deep in the long grass. It was unable to repay the money it had borrowed in the market. Sentiment soured. Investors felt a prickle down the back and started edging for the door. Needing cash, the bank asked the Bank of England if they wouldn’t mind tying them over. Word got out. Weary commuters got home, turned on the TV and saw news bulletins of people queuing outside branches with excited presenters talking about the country’s first bank run for 150 years. And that was about it for Northern Rock. Trust evaporated. The bank was finished.

On February 22nd 2008 Northern Rock was taken into state ownership. Shareholders got wiped out. The government eventually sold the bank to Richard Branson’s Virgin Money. The brand disappeared and everyone agreed not to do it again.

Banks operate on trust. Once that goes, there is nothing much they can do about it. Wealth takes a lifetime to build up but can get wiped out quicker than Paul Daniels once muttered “Over to my wonderful assistant, Debbie McGee.” Actually, it can disappear a lot quicker than that.

The collapse of Northern Rock is a sorry tale of greed, lax oversight and hubris. For those who lost their life savings it was a whole lot worse.

Be careful who you trust.

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