Still hanging on one year later

On the first anniversary of the Northern Rock crisis, critics say the Government still has a mountain to climb.

IF THE beleaguered Prime Minister Gordon Brown and his Chancellor, Alistair Darling, were hoping for some moral support from Mervyn King, the Bank of England governor, they were to be disappointed. King has already appeared imperious over the Government in his handling of the economic crisis and last week, as he faced members of the cross-party treasury committee, he merely added to the Cabinet's sense of disarray.

The governor cautioned ministers against a US-style bail-out of the struggling housing market. There was no magic solution to the credit crisis, he said, but heavy Government intervention would risk undermining any incentive the banks may have to put their own houses in order.

His remarks came at a critical time as this weekend marks the first anniversary of the collapse of Northern Rock which has prompted 12 months of hand-wringing and panic as the Government has tried to restore calm to the markets.

Darling's announcement of the Rock's bail-out at 7am on Friday September 14, 2007, had the unwanted effect of causing the first run on a bank since Queen Victoria was on the throne. Pictures of queues of customers desperate to withdraw their savings were beamed across the world. The former building society became a global phenomenon for all the wrong reasons and consumer confidence in financial institutions and the Government was severely dented.

In the 12 months that have passed, Northern Rock has been nationalised, reduced the volume of lending and withdrawn its risky, high loan-to-value deals. Commentators estimate it will complete only £5bn of lending this year, down from £60bn at its peak.

The lending it has carried out is largely to pay off its loan to the Treasury, which Simon Ward, economist at New Star Asset Management, estimates now stands at £15bn, down from a high of £17.5bn.

But despite salvaging the Rock from complete ruin, commentators are not convinced that the Government and financiers have learned a great deal in the past year. Most also agree there is little the Bank of England, the Treasury or the Financial Services Authority can do to boost the UK housing market and economy, given the global nature of the downturn and that King may be right in saying that to a large degree it will be up to the markets to correct themselves.

King's message was clear. While it's fine for short-term liquidity to be injected into the banking system, he will not recommend measures to provide long-term mortgage funding for lenders.

This week, King will unveil details of a new temporary liquidity support system to replace the Special Liquidity Scheme that was introduced for six months in April to allow banks to swap mortgage security for Government debt to strengthen their balance sheets. Banks should not be holding their breath for any more permanent assistance.

King is not alone in his view that state intervention should be limited if the market is to recover. Gwilym Price, professor of urban Economics at the University of Glasgow, says: "Rising Government debt and falling tax revenues as the economy slows limits the Government's capacity to take action. It's questionable whether the state should attempt to prop up the housing market."

But what is without question on both sides of the Atlantic is the unexpected severity of the credit crunch. Michael Baxter, economist with Defaqto, says: "Twelve months ago, the credit crunch was seen as a temporary difficulty. Analysts drew parallels with the crisis of 1998, and reminded us that the 1988 crisis soon became little more than a footnote to recent economic history. Twelve months on, a pantheon of the great and the good, including Alistair Darling, former Fed chairman Alan Greenspan and George Soros have described the current crisis as the most serious in 60 years."

Despite the scale of the downturn, the Government seems to think a full-blown recession can be avoided.

When the Chancellor addressed the Trades Union Congress in Brighton last week, he admitted times are tough, but declared: "I am confident that we will get through this" as long as the mistakes of the past are avoided.

His basis for such hope is that the UK economy is stronger than in the 1970s, Eighties or early Nineties and its problems are not "home-grown". Darling said: "Most people understand that the problems we face are global. They recognise no country or government can turn back these global economic forces on its own."

Jeremy Tigue, head of global equities at F&C Asset Management, says: "Short of adopting the US measure of nationalising the mortgage market, which is a drastic thing to do, the Government has to let things work though. It has to let house prices fall to a level that people can afford to buy again and first-time buyers can come back in to the market."

Until banks get their balance sheets in order, the credit crunch will continue, according to Ken Taylor, director of Mackenzie Taylor Wealth Management.

"People need to accept that we are in for a rough ride this winter and beyond. There is no magic fix about to be applied. We have enjoyed an unbroken run of prosperity over the last decade, but the majority of it was financed by debt, which is now coming home to roost."

Tigue believes that inflation fears will ease in the coming year and allow the base rate to be cut from its current level of 5% to help restore consumer confidence and reduce the cost of mortgages.

Geoff Tresman, chairman of Punter Southall Financial Management, thinks it is wrong for the Government to insist on an inflation target of 2% claiming it is standing in the way of the Bank cutting interest rates to a level – around 3% – which would have some impact. He would also like to see Stamp Duty abolished on houses up to £250,000.

Some organisations, such as the National House Building Council, have called for the SLS to include new mortgages, not just ones that have been on lenders' books since before 2007, to allow banks to raise more funding. Not surprisingly, King is not in favour of such an extension.

Many experts believe the UK will start to recover from next spring and the fall in the value of sterling will help boost exports. There have also been calls for the shake-up of the tripartite system of regulation.

Tresman says: "Everyone praised the new Labour Government in 1997 for giving the Bank of England the job of setting interest rates. But look at what has happened since. The problems at the likes of Northern Rock were not picked up by the Bank, FSA or Treasury."

This is first time the tripartite arrangement has been tested and, according to Tigue, the three parties must learn from the fact it has not coped well with the credit crisis. There is concern that the real causes of the credit crunch are still not fully understood. Baxter's view is that it was not caused merely by a few over-exuberant bankers and is not just a result of the US sub-prime debacle.

"The reality is that much of the developed world witnessed a property bubble expand and expand, yet few could see it for what it really was. This left both banks and the public exposed to grossly-inflated property values," he says.

He adds that the beginning of the end of the credit crunch will occur only when there is a widespread appreciation of its underlying cause, and when house prices fall to a level that is sustainable – something unlikely to happen in the foreseeable future.

Other commentators share the concern that those who have exacerbated the credit crunch have not faced up to their errors of judgment.

Tresman points the finger of blame partly at "greedy" individuals in charge of Northern Rock and other institutions which were on the brink of collapse.

"Good, old-fashioned lending principles were thrown out of the window. In their place was a dash for profit, driven by greed," he says.

He said that one of the lessons must be a realisation that banks and insurance companies should be more closely scrutinised and the individuals running them need to fully understand the financial services industry. For example, if a bank's share price falls dramatically, the management should be removed.

According to Peter Hensman, global Strategist at Newton Investment Management, a return to "safe", traditional lending is now under way, but this will hinder a fast recovery in the housing market and wider economy.

"For the UK that has enjoyed several years of easy availability of debt finance that supported a property and consumption boom, the return to a more traditional banking model is likely to be a drag on activity for some time," says Hensman.

But the decision last Sunday for the US Fed to become a white knight for Fannie Mae and Freddie Mac, the quasi-private institutions that finance or guarantee nearly half of all US mortgage debt, did bring a glimmer of hope to global markets.

The US government was forced to intervene to prevent the collapse of the lenders, which Tigue said would have been a "cataclysmic disaster". If the two companies had been allowed to go under, the entire US market would have seized up and damaged the world's financial system.

The move, in particular the US government's decision to buy mortgage backed securities, will help restore confidence and inject some much needed liquidity into global markets. This means the government will buy mortgage assets which have been bundled together to provide funding to lenders to do more business.

On the down side, the Fed's intervention has generated a massive bill for the US government and all tax payers. Fannie and Freddie have been given $50bn by the Fed to continue lending, but the total bill may be in the region of $200bn.

There is also the danger that the US government has increased the chance that banks will not learn their lesson from the excessive risk taking that caused the credit crunch.

With a year of the credit crunch under our belts, everyone will want to avoid a repeat of a failure in the UK on the scale of Northern Rock.

Tresman says: "Providing the other financial institutions in the UK have come clean with their own problems and are not hiding anything off balance sheets, then I believe we have seen the last of this particular type of failure."

Timeline

April 2007: New Century Financial, which specialises in US sub-prime mortgages, files for Chapter 11 bankruptcy protection.

July 2007: Bear Stearns investment bank is the first high-profile sub-prime casualty.

September 2007: Northern Rock is rescued with emergency finance by the Bank of England.

October 2007: UBS and Citigroup reveal billions of dollars of sub-prime related losses. Merrill Lynch chief Stan O'Neal, resigns after the bank unveils a $7.9bn exposure to bad debt.

December 2007: The Bank of England cuts interest rates by a quarter of 1% to 5.5%.

February 2008: Bank of England cuts interest rates to 5.25%. Government announces Northern Rock is to be nationalised for a temporary period.

April 2008: Bank of England cuts interest rates to 5% and announces a £50bn plan to help banks by allowing them to swap risky mortgage debts for government bonds. Royal Bank of Scotland announces a £12bn rights issue.

May 2008: Bradford & Bingley tries to raise £300m of cash from its shareholders.

September 2008: America's two largest lenders, Fannie Mae and Freddie Mac, are bailed out by the US Federal Bank.