As interest began falling from 2000 – 2004 there was sharprise in house prices which was followed by decline in 2007 that occurred aftera period of rising interest rates from 2004 to 2007.
The mortgages would bepackaged into pools that were divided into tranches according to the risk andreturn which led to the creation of Collateralized Debt Obligations (CDO’s).This activity led to the creation of subprime mortgages which were loans made toborrowers who didn’t qualify due to poor credit rating or low income, there wasan increase in subprime mortgages between 2000 and 2006 from 2% to 17%. As morepeople who were previously unable to qualify for mortgages increased so diddemand and house prices increase. The high risk lower low household incomemortgages were rated as safe by Moody’s and Standard and poor, when interestrates started to rise in 2004 many lower income households were unable toafford the mortgage thus began to default which led to a decline in wealth fromhome equity. As the bubble burst there was no incentive to lend more due to theincreasing interest rate and private institutions became more cautious lendingout as they couldn’t no longer accurately value the mortgage backed securitiesforcing them to write of billions off their books with some banks such asLehman Brothers and Northern Rock failing. The existence of banks is to act as financial intermediariesbetween savers and borrowers, one of the ways that banks engage inintermediation is through different forms of transformation.
Banks will performdifferent types of transformation such as maturity transformation whichinvolves taking short term deposits and transforming them to long term loans(i.e. mortgages).Changes in interest rates often impact bank performance, banksbusiness models often involve paying a lower rate interest on short termdeposits and receiving a high rate of interest on long term borrowing. The longperiod of low interest rates gave the assumption that rates would remain low,which led to Northern Rock adopting a business model that was based onborrowing from the capital markets to fund its loan book instead of funding itfrom deposits. The period of lower interest rates meant that it was cheaper fornorthern rock to borrow from the wholesale markets and left it exposed tochanges in interest rates. More than 70% of loans made by northern rock wasfunded by capital markets which was a higher proportion than other lenders.
When interest rates began to increase in 2007 it became more expensive fornorthern rock to borrow from the wholesale markets which resulted in anincrease in the cost of funding and an impact on the net interest income. Northern Rocks coremarket was the mortgage market which was supported by increasing demand forproperty by first time buyers, university leavers and immigrant labour. Changesin Interest rate were not the only factors that impacted Northern Rock but itwas exposure to the mortgage markets through its securitisation activities.
Thesecuritization of mortgages became a profitable activity that privateinstitutions were willing to accept to gain a competitive advantage. In 2006Northern completed its single biggest securitisation issue totalling £6 billionwhich was based on the growing appetite for securitisation from the USA andEurope as stated by the CEO Adam Applegerth.Changes in interest rates willoften impact buying trends, the low interest rate period provided incentive forthese groups of first timer buyers or existing mortgage holders to acquiremortgages or refinance due to the low cost of borrowing.
When interest ratesbegan to increase it became more expensive for lower income households tomaintain mortgages which led to defaults as defaults occurred this led tolosses on the mortgage backed securities, sub-prime mortgages and the collapseof securitisation issuance. Nationalisation of Northern Rock was due to a lack offunding, the bank was heavily dependent on securitisation issuance and fundingfrom the wholesale markets. As defaults increased on the mortgages NorthernRock 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 insub-prime mortgages, banks and investors became less willing to lend to otherbanks particularly those that were involved in securitisation issuance.
NorthernRock failed to meet its short-term obligations which led to its customersrushing to withdraw their money, at the time Northern Rock had short term wholesale obligations of 60% . Due to its lack of funding Northern Rock reached outto lender of last resort the Bank of England for liquidity assistance, to providestability and reduce the bank run the labour government had to step innationalise Northern Rock. The nationalisation of Northern rock led to a number ofoutcomes some of which were positive and negative. Nationalisation of NorthernRock was intended to be a temporary solution that would provide stability untilmarket conditions improved and then the tax payer would gain on the sale of theassets acquired.After the nationalisation Northern Rock was under pressure fromthe government and cut its interim dividend, at this point shareholder wealthhad been at a loss from the already falling share price. Other steps taken torestructure Northern Rock included breaking up the bank from its retail andasset management, the asset side of bank which contained the toxic assets wasto be held by the government and the rest sold off.Nationalisation not onlyaffected the share price and caused equity loss but structural changes had tobe made such as staff downsizing which resulted in job losses and changes to managementsuch as Bryan Sanderson replacing Matt Ridley as chairman.
The nationalisationof Northern Rock began to provide some form of stability and confidence asinterests from the private sector began to come in, one of them being theVirgin 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 itssurvival at a time of panic and instability it provided reassurance and helpedto restore confidence in the bank, it gave the perception that since it wasbacked by the government the government would not let it fail. However thesechanges were not beneficial to all stakeholders, shareholders lost their equitywhen the share price collapsed and , some shareholders such pensioners andthose who had self invested pensions (SIPS) in Northern rock lost all theirlife savings. After nationalisation of Northern Rock shareholders lost controlof the mortgage bank, legislation was proposed that the government should not compensatethe shareholders for any value.
The tax payer that helped fund the bailoutbenefited from the sale of assets from the Northern Rock Asset management sidethat received loans and was kept under the government. The nationalisation had a negative impact, it resulted inloss 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 taxpayer did benefit from the sale of banks assets but the initial funding costthe tax payer, returns on the initial funding was dependant on the governmentsability to find a buyer for the banksassets.