Saturday, February 23, 2008

Market Forces .... Part II

Northern Rock was a building society whose management gambled on a strategy of borrowing from other financial institutions, rather than using customer deposits. This strategy went disastrously wrong as the sub-prime mortgage crisis spread around the money markets. The Government was then expected to bail them out with huge wads of public money, which it did. It was then discovered that most of Northern Rock's valuable mortgage assets had been used as securities for loans. The securities vehicle raising the finance was an off shore fund called 'Granite' and the money raised had already been used by Northern Rock.

If you have a 100% mortgage on your home, then you really don't "own" it. In much the same way, Northern Rock doesn't really "own" most its most valuable assets.

This is a company in which the Government has risked £100bn of public money. The government is now planning to nationalise Northern Rock which of course has the current shareholders screaming that they should still be paid for this car crash of a company. It should be remembered that some of these shareholders were less than supportive in attempts to find an alternative option and most of the value in the company has already been wiped out by reckless management. I wonder why they think they should be rewarded? Prudence? Good Governance?

Not everyone has lost out, some of the lawyers and bankers who have been advising the Government are demanding a huge £100 million windfall and apparently the CEO had made a few bob or two by trousering the profits from the sale of 1.5 million shares at the beginning of the year. The biggest loser seems to be the tax payer.

Let's be clear, the only people responsible for the failed strategy were the management and the shareholders. The management chose the strategy and the tactics, which crashed the bank when the environment changed. The shareholders chose the management.

As of 2006, we know that Northern Rock had £86 billion in mortgages and loans assets and £40 billion in securitised notes. As mentioned above, the securitised notes were against the mortgage and loans business. Now, we don't actually know how much this has increased to in 2007 but according to the Guardian it includes over £53 billion of residential mortgages. So I'll have to guess that this leaves an actual mortgage and loan book of say £40 billion or less. Some would argue the value of this could be much lower.

This system of securitising mortgages worked, as long as other investors were willing to buy the securities. Unfortunately the wobbles about the sub-prime market changed the game and the bank ran out of cash. Northern Rock had to borrow from the Bank of England and this caused the run. The bank has had to continuously borrow more and apparently the loan now stands at a £30 billion.

A £40 billion mortgage and loan business to cover customer deposits, a government loan and any existing bonds! This loan and the Government guarantee is what is keeping Northern Rock afloat.

Public money is at risk, and we, the public, want our money back with a good return. I'd also like to know more about PwC's role in all of this, and how comes £40m was distributed to preference share holders.

As I said before:

"Its a shame that good old market economics are dandy as long as things are going up, but when it's on the way down the banks want to be bailed out by good old state intervention."

Whilst the financial market is quite happy to make a fast buck out of the state as per the QinetiQ fiasco and Black Wednesday, it is also quite prepared to shriek about "minimalist intervention" (aka Friedman's folly) and the need for "self-regulation" when that is more advantageous. We even have the EU Internal Market Commissioner, Charlie McCreevy, accusing the banks of "failing standards".

It's the same old story: "Government interference in the market is wrong, the market should regulate itself" UNTIL "the market can't regulate itself, that's the Government's job".

Adam Smith knew that markets were no more than a tool to be used by society and that they needed control. The market is part of society and not the other way around. The Government should be a firm and visible hand, providing consistency but remaining suitably distant from business. Unfortunately we have allowed MG and other manufacturing companies to go the wall whilst we bail out financial services - so no consistency. We even hold meetings with oil companies to discuss post war economic opportunities in Iraq before the first bombs have dropped - too cosy a relationship for my liking.

There needs to be some distance put between Government and business, some consistency in intervention, a realisation that the markets need firm regulation (as per Keynes and Smith) and an understanding that Government's role isn't for the benefit of the market but for the benefit of society.

Judging by the recent howls about the changes to non-doms and other recent interventions, it looks like this might just be starting to happen.

Good Old Brown & Alastair.

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