Rock Shock

I'd been working late and was on the way home when this story broke.

Northern Rock has struggled to raise money to finance its lending ever since money markets seized up over the summer, in the wake of the US sub-prime loans crisis.

The decision for the Bank of England to become the "lender of last resort" is extremely rare - and also comes after consultation with the Financial Services Authority.

According to our business editor, the chancellor, Bank and FSA will make clear that the emergency facility enjoyed by Northern Rock will be made available to any other bank that runs into similar liquidity problems - as against more fundamental solvence issues.

I'm not sure I understand this. I gather there's no issue with solvency, but they can't continue to lend money unless they borrow it, because they haven't got a big enough base of depositors. The Bank of England are lending at "a punitive rate of 6.75%". But the 3-month inter-bank lending rate (LIBOR) is only 0.13% higher at 6.88% - why can't they borrow there ?

Ah - LIBOR reflects short-term loans - up to a year. Presumably NR want long-term money to match the long-term mortgages - or do they live hand to mouth, so to speak, on a succession of short term loans ? Seems like a risky strategy to me. How is the money that've already borrowed (and lent out) financed - short or long term loans (short - see update 2) ?

You have to presume that it's not the interest rates so much as that the other banks are refusing to lend to NR.

If that's true, what do the other banks know that the Bank of England is prepared to ignore ?

If they can't borrow the money at a rate which will enable them to offer attractive mortgages, why don't they just stop new lending ? Presumably the answer is that they'd be basically shutting up shop to new business, with no future profits to look forward to and a huge share price fall. But why should the BoE be concerned with that ?

If LIBOR is at nearly 7% I'd have thought that implies 8% mortgage rates before too long.

I'm sure Tim Worstall and Chris Dillow will explain all.


UPDATE - Willem Buiter is not sure that they ARE necessarily safe from insolvency risks, and is distinctly sceptical about the bailout.

Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let’s hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.

UPDATE2 - it appears they are indeed lending over long periods, but getting the money to lend via a series of short term loans.

Northern Rock said in a statement on Friday that the Bank of England had agreed to provide it with as much funding “as may be necessary” as it warned that it would otherwise be incapable of refinancing maturing liabilities and flagged that full-year profits would be 20 per cent below consensus forecasts.

Those maturing liabilities being the previous short term loan which is now due for repayment.

Analysts at Cazenove said in a note: “We assume Northern Rock will cease writing new business. The lack of new business flow and a penalty cost of funding will have a detrimental impact upon Northern Rock’s earnings ... Northern Rock is unlikely to remain independent but the value of the company to an acquirer may be significantly below the current share price.”

So they will stop new business, but because they still need to refinance the existing loans, that isn't the end of their woes. Hence the BoE bailout.

Meanwhile the rush for the exits continues. If investor sentiment is driven by greed or fear I think we know which is uppermost today.

Declaration of interest - I have a mortgage with Northern Rock, who took over the Legal and General portfolio when that company got out of the mortgage market. I wonder if they'd like me to pay it off ?


UPDATE3 - an anonymous commenter at Willem Buiter :

Laban - this basically comes down to NRK being unable to roll their commercial paper. By that I mean, they have borrowed using commercial paper which is now coming due. They are seeking to issue new commercial paper in order to borrow and thus repay the creditors of the old commercial paper. That probably came due on Monday, and it takes 2 days to settle so they had to sell it yesterday (Thursday). They failed to sell it and have to go to the BoE instead.

Interestingly, this is exactly the same thing that caused Enron to finally succumb to failure (they were unable to roll their CP too). The only difference is they didn't get a bail-out.

OK - now you want to know about commercial paper. I'd not heard of it either. It's all here.

In essence, the commercial paper market is used by companies in need of short-term loans. They issue commercial paper, which is like a bond, as an IOU. Banks are big users of commercial paper. The banks package up billions of dollars of loans made to consumers or companies, through products such as mortgages and credit cards, into special financing vehicles called “conduits”. The banks then sell on the loans held within the conduits to investors, such as money market funds, insurance companies or other banks. They do this by issuing the commercial paper. The life of the commercial paper is typically very short, about 55 days. When the time is up, the bank managing the conduit will go back to the investors and roll over the commercial paper into another short-term agreement with similar interest rates.

In the United States, there is about $2.2 trillion (£1,100 billion) of commercial paper. About half of this is unsecured, like a personal loan taken out by a consumer, but $1.2 trillion of it is so-called asset-backed. This means that the loans are secured against assets such as the bank’s book of mortgage business.

The commercial paper market in Europe is worth $840 billion, of which about $300 billion is asset-backed commercial paper.

For the most part, the commercial paper market carries out its day-to-day business and rarely hits the headlines. In the past few weeks, however, interest rates in the market have hit six-year highs as panicky investors have refused to roll over the paper. Instead of reinvesting in commercial paper that is coming to the end of its 55 days, investors are turning to other short-term safe havens, such as US government debt.