As books with some banks such as Lehman Brothers

As interest began falling from 2000 – 2004 there was sharp
rise in house prices which was followed by decline in 2007 that occurred after
a period of rising interest rates from 2004 to 2007. The mortgages would be
packaged into pools that were divided into tranches according to the risk and
return which led to the creation of Collateralized Debt Obligations (CDO’s).

This activity led to the creation of subprime mortgages which were loans made to
borrowers who didn’t qualify due to poor credit rating or low income, there was
an increase in subprime mortgages between 2000 and 2006 from 2% to 17%. As more
people who were previously unable to qualify for mortgages increased so did
demand and house prices increase. The high risk lower low household income
mortgages were rated as safe by Moody’s and Standard and poor, when interest
rates started to rise in 2004 many lower income households were unable to
afford the mortgage thus began to default which led to a decline in wealth from
home equity. As the bubble burst there was no incentive to lend more due to the
increasing interest rate and private institutions became more cautious lending
out as they couldn’t no longer accurately value the mortgage backed securities
forcing them to write of billions off their books with some banks such as
Lehman Brothers and Northern Rock failing.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now


The existence of banks is to act as financial intermediaries
between savers and borrowers, one of the ways that banks engage in
intermediation is through different forms of transformation. Banks will perform
different types of transformation such as maturity transformation which
involves taking short term deposits and transforming them to long term loans
(i.e. mortgages).Changes in interest rates often impact bank performance, banks
business models often involve paying a lower rate interest on short term
deposits and receiving a high rate of interest on long term borrowing. The long
period of low interest rates gave the assumption that rates would remain low,
which led to Northern Rock adopting a business model that was based on
borrowing from the capital markets to fund its loan book instead of funding it
from deposits. The period of lower interest rates meant that it was cheaper for
northern rock to borrow from the wholesale markets and left it exposed to
changes in interest rates. More than 70% of loans made by northern rock was
funded by capital markets which was a higher proportion than other lenders.

When interest rates began to increase in 2007 it became more expensive for
northern rock to borrow from the wholesale markets which resulted in an
increase in the cost of funding and an impact on the net interest income.

 Northern Rocks core
market was the mortgage market which was supported by increasing demand for
property by first time buyers, university leavers and immigrant labour. Changes
in Interest rate were not the only factors that impacted Northern Rock but it
was exposure to the mortgage markets through its securitisation activities. The
securitization of mortgages became a profitable activity that private
institutions were willing to accept to gain a competitive advantage. In 2006
Northern completed its single biggest securitisation issue totalling £6 billion
which was based on the growing appetite for securitisation from the USA and
Europe as stated by the CEO Adam Applegerth.Changes in interest rates will
often impact buying trends, the low interest rate period provided incentive for
these groups of first timer buyers or existing mortgage holders to acquire
mortgages or refinance due to the low cost of borrowing. When interest rates
began to increase it became more expensive for lower income households to
maintain mortgages which led to defaults as defaults occurred this led to
losses on the mortgage backed securities, sub-prime mortgages and the collapse
of securitisation issuance.

Nationalisation of Northern Rock was due to a lack of
funding, the bank was heavily dependent on securitisation issuance and funding
from the wholesale markets. As defaults increased on the mortgages Northern
Rock was faced with a crises of not receiving payment from its long term loans.

The credit crunch led to a shortage of funds due to an increase in defaults in
sub-prime mortgages, banks and investors became less willing to lend to other
banks particularly those that were involved in securitisation issuance. Northern
Rock failed to meet its short-term obligations which led to its customers
rushing to withdraw their money, at the time Northern Rock had short term whole
sale obligations of 60% . Due to its lack of funding Northern Rock reached out
to lender of last resort the Bank of England for liquidity assistance, to provide
stability and reduce the bank run the labour government had to step in
nationalise Northern Rock.


The nationalisation of Northern rock led to a number of
outcomes some of which were positive and negative. Nationalisation of Northern
Rock was intended to be a temporary solution that would provide stability until
market conditions improved and then the tax payer would gain on the sale of the
assets acquired.After the nationalisation Northern Rock was under pressure from
the government and cut its interim dividend, at this point shareholder wealth
had been at a loss from the already falling share price. Other steps taken to
restructure Northern Rock included breaking up the bank from its retail and
asset management, the asset side of bank which contained the toxic assets was
to be held by the government and the rest sold off.Nationalisation not only
affected the share price and caused equity loss but structural changes had to
be made such as staff downsizing which resulted in job losses and changes to management
such as Bryan Sanderson replacing Matt Ridley as chairman. The nationalisation
of Northern Rock began to provide some form of stability and confidence as
interests from the private sector began to come in, one of them being the
Virgin group interest which resulted in a sale of one part of the bank between
£747 million and £1 billion.

The nationalisation of Northern Rock was essential to its
survival at a time of panic and instability it provided reassurance and helped
to restore confidence in the bank, it gave the perception that since it was
backed by the government the government would not let it fail. However these
changes were not beneficial to all stakeholders, shareholders lost their equity
when the share price collapsed and , some shareholders such pensioners and
those who had self invested pensions (SIPS) in Northern rock lost all their
life savings. After nationalisation of Northern Rock shareholders lost control
of the mortgage bank, legislation was proposed that the government should not compensate
the shareholders for any value.The tax payer that helped fund the bailout
benefited from the sale of assets from the Northern Rock Asset management side
that received loans and was kept under the government.

The nationalisation had a negative impact, it resulted in
loss of wealth for shareholders and control of the mortgage bank to the public.

Nationalisation of the bank was funded by the tax payer, eventually the tax
payer did benefit from the sale of banks assets but the initial funding cost
the tax payer, returns on the initial funding was dependant on the governments
ability  to find a buyer for the banks