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FROM A ROCK TO A PEBBLE
By John Newsome on 9th September 2008


It has taken six months but the final chapters of the Northern Rock saga are about to be written. The first run on a bank since the 19th century will end in nationalisation by a government that was desperate to avoid taking such action. There will likely be legal moves, spearheaded by the two hedge funds that account for almost a fifth of its equity, so the story will run for a bit longer yet. However, with a private sector rescue off the agenda, now is a sensible time to look back and analyse just how this extraordinary situation came about.


The first point to make is that Northern Rock's management failed to grasp the potential dangers of the business model they willingly adopted. In a nutshell, instead of relying upon customer deposits to fund the majority of its loans, it turned to wholesale money market borrowing. This short term funding required regular renewal and was, therefore, extremely vulnerable to a situation where wholesale money became harder to come by. To a degree, all banks use wholesale markets to part fund their loans but by allowing it to reach 75% of advances, Northern Rock was at the mercy of a change in sentiment where banks became less inclined to lend to one another. Today's credit crunch, with its origins in the US sub-prime mortgage market, was just such an event.


So, why did Northern Rock's management pursue such an aggressive funding structure? Well, that is very easy to answer; it was because it delivered high growth and that's a commodity the stockmarket worships. Which neatly answers why so many stockbrokers and investment managers were happy to buy the shares. They were more concerned with potential returns rather than the very real risks associated with Northern Rock's unusual funding structure.


We declined to purchase Northern Rock shares because we did not like the way it operated or the condition of its balance sheet. We were also uncomfortable with the fact that with less than 80 branches, it managed to gain almost 20% of net new residential mortgage business. Such market share was far in excess of that enjoyed by much larger rivals and was a telling statistic with regard to how dependent the group was on wholesale funding.


The government's use of the word temporary to describe its ownership of Northern Rock is a little disingenuous; the Hundred Years' War could be described as temporary. While we don't expect public ownership to last quite that long, make no mistake, Northern Rock will be under government ownership for years. As for the possibility of shareholders securing any meaningful level of compensation, in our opinion, the chances are close to zero. Northern Rock would have been insolvent without government backing and any level of compensation will reflect that.


That's bad news for RAB Capital and SRM Advisers, the two hedge funds that owned almost 20% of the shares. The pair requested a recent shareholder meeting and implied the Bank of England had mishandled the credit crisis. John Wood, head of SRM, said that Northern Rock built its business with the knowledge it could borrow from the Bank of England as the lender of last resort in case of crisis. With logic like that, it's difficult to feel overly sympathetic.


John Newsome can be contacted on:
01423 705123


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