Will Hutton: When net income won't cover gross habits

By Will Hutton
The Observer, London
Sunday, September 16, 2007

http://observer.guardian.co.uk/comment/story/0,,2170289,00.html

After hubris, nemesis. Last week Northern Rock, Britain's fifth biggest mortgage lender and the former darling of the financial markets, was forced to turn to the Bank of England for cash because no City lender would support it for fear the company was about to go bust. When the announcement broke overnight on Thursday, ordinary savers followed the City's lead -- jamming the company's switchboard and queuing outside branches to take as much as L1 billion out in a day.

This is a full-blown run on a bank, something we have not seen on such a scale since the 19th century, and a measure of the depth of mismanagement, non-regulation and structural dysfunctionality of today's financial system. The message from on high is that, unlike the money markets which have seized up from panic in the aftermath of the American property and lending crisis, ordinary savers and borrowers should not worry their little heads and stay calm.

For savers with less than L2,000, the advice is right -- the depositors' compensation scheme will fully reimburse them.

But larger savers, whose compensation is limited to 90 percent of their savings, will see no reason why they should run the risk of losing 10 percent of their assets. Nor, if Northern Rock does go bust, why they should go through the uncertainty, worry, and hassle of the government organising a takeover to see if their savings will ultimately be protected. The City is not prepared to run that risk, so why should they?

The chancellor, among other government ministers, exposed himself to the risk of law suits and the charge of misleading citizens with such obviously poor advice. He was in a bind. If he didn't say something reassuring, then a small panic could have become a big panic and fed itself. Equally, they must have known that their reassurances were risky. It was not a happy position.

Those who preach light regulation, non-intervention, and the perfectability of free financial markets must face the consequence of their actions. For Northern Rock is in a very dangerous position as its plunging share price shows; there are a number of other lenders -- some household names, some not -- in a similar if currently less serious fix. The bank faces a twin threat.

First, its capacity in London's money markets, on which it depends for as much as 70 percent of its funds, has been profoundly compromised by the Western banking system's discovery that there is as much as $200 billion of valueless American mortgages parcelled up and sold round the world, in such a way that nobody can know which banks are going to take the hit.

This, so the doctrine went, laid off the risk just as a bookmaker does. But bookies know that they cannot lay off the risk completely. Despite their fabulous bonuses, bankers can be clever fools. They assumed that once the risk was laid off, it would not matter if there was a default. They, and the uninquisitive regulators, have learnt a sharp lesson. The London inter-bank market, in which banks lend to each other, is paralysed by fear and Northern Rock, with its need for ready cash, has become the first big name casualty.

The bank's second problem is that it has been a principal player in what is, in effect, a British sub-prime mortgage market. It has been one of the most aggressive in lending mortgages that represent not merely 100 percent of the value of a house, but sometimes up to 125 percent. It has lent as much as five or even six times borrowers' earnings. It has also aggressively lent to buy-to-let entrepreneurs, who can be paying out mortgage interest that is twice what they receive in rents.

Nobody outside the company knows what proportion of its more than L100 billion of loans has been lent on such terms. And those mortgages are dependent on the now questionable assumption that house prices will carry on rising and every lender will service their mortgage payments. What we do know is that technical insolvency would be triggered if just 5 percent of its loans were never repaid. The experts and government say it is not going to happen. I share the market's view that such certainty is impossible.

How to respond?

The Bank of England is treading the finest of lines, with its governor, Mervyn King, insisting that he and the bank are against bailouts because of the message they send -- that reckless banks pay no price and it is wrong to inject cash into the system because of the inflation it will cause. Yet on Thursday evening the Bank of England announced what is in effect a bailout for Northern Rock, rescuing depositors, shareholders, and management; if it had not acted, the bank would have ceased trading.

What remains of the Bank of England's vaunted hardline reputation depends on the terms of the so-far secret deal. If the bank has supplied cash at a genuinely punitive high-interest rate so Northern Rock can make no margin on its lending, then the governor can just about argue that all he has done is to keep the bank alive (while savaging its profits rather than bailing it out), limited the collateral damage to the wider economy, and forced Northern Rock to pay a price for its recklessness, even if it is less than bankruptcy.

Nevertheless, it is playing with words. This is a bailout as long understood in the canons of central banking, and Professor King has had to buckle because to let Britain's fifth largest mortgage lender go bust would have caused incalculable damage.

Make no mistake. Britain's financial system is in the most precarious position since the war. In 1974 there was a banking crisis caused by banks lending far too much on speculative property deals, but the so-called "secondary" banks were then at the periphery of the system.

The inter-bank market continued to function. There was no public run on a bank the size of Northern Rock. And the British system was not so closely linked to the fate of the American mortgage market or, indeed, to the Chinese economy, where British banks have paid top prices for stakes in valueless Chinese banks whose bad lending makes Northern Rock look positively virtuous.

So the stakes are much higher now -- hence the Bank of England's bailout -- and my guess is that there is more to come. The potential impact on house prices and the wider economy is obvious; even if a downturn is averted, these risks should never have been run. The pictures of Gordon Brown having tea with Lady Thatcher in Downing Street in the middle of a bank run could hardly have been more compromising. It was her philosophy that above any other has led us to this pass. Winston Churchill once pronounced that in Britain, finance is too proud, industry too humble.

Proud finance has insisted it needs no regulation, that it can be trusted to deploy the nation's savings with care. The trust has been abused. We need a solid, social democratic government to reduce the risk of such recklessness in future, not tell us that finance should be left to finance while the taxpayer picks up the pieces. I hope Mr Brown is embarrassed. If he is not, so much the worse for all of us.

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