Why Can't Northern Rock Raise Short Term Funds At Any Price In The Open Market?

Adrian Ash - Mon 17 Sep, 2007

"Northern Rock is a prime-only lender," says the distressed borrower itself today, "and credit quality on all its loan books remains strong. Three-months plus arrears in the residential book were 0.47% at the end of August, still under half the industry average." No sub-prime in them thar' loans! So why can't Northern Rock raise short-term funds at any price in the open market? Well, "in the first eight months of the year, Northern Rocks total net lending was up 43% over the same period in 2006, with net residential lending up 55%," as it proudly states today. Perhaps this aggressive growth explains the rest-of-the-world refusing to lend it cash.

Gulp! So the sub-prime crisis was ‘contained’, was it? Then how come the FTSE's off 2% already today? How come stock in the UK's fifth largest mortgage lender — with only 0.24% of its total assets exposed to US sub-prime — has dropped by one quarter in three short hours?

And how come "long lines of customers have formed outside several Northern Rock branches around the UK" today, as the BBC reports? How come there's a run on the bank?

"I think that anybody who is waking up this morning who is either a saver with Northern Rock or has got a mortgage," said Angela Knight, head of the British Bankers Association on Radio Four this morning, "can be absolutely confident that they have got their money with or they have borrowed from a very sound financial institution."

But then she would say that, wouldn't she. As for Northern Rock itself, "it has now become clear that the global credit and liquidity markets have not recovered in the early part of September," says a statement from the distressed lender today. They're not kidding.

"Accordingly, Northern Rock has agreed with the Bank of England that it can raise such amounts of liquidity as may be necessary by either borrowing on a secured basis... or entering into repurchase facilities."

Gasp! So the Bank of England has done just what Mervyn King said it might when The Trimmer tried to calm the markets on Wednesday... and it's now stepped in as ‘lender of last resort’?

"Northern Rock is a prime-only lender," says the distressed borrower itself today, "and credit quality on all its loan books remains strong. Three-months plus arrears in the residential book were 0.47% at the end of August, still under half the industry average."

No sub-prime in them thar' loans! So why can't Northern Rock raise short-term funds at any price in the open market?

Well, "in the first eight months of the year, Northern Rock’s total net lending was up 43% over the same period in 2006, with net residential lending up 55%," as it proudly states today. Perhaps this aggressive growth explains the rest-of-the-world refusing to lend it cash.

Built by borrowing short to lend long — rather than by the old fuddy-duddy method of attracting cash savers and then lending out their deposits — Northern Rock's spectacular growth relied on cheap and plentiful liquidity. That's what the City of London knew. The capital's hacks, on the other hand, did not.

"Buy" said The Times on July 27th. "Buy" said The Telegraph the same day. "I have bought Northern Rock," added an FT journalist one month later, "unable to resist a price of 645p, which gives a forward p/e of 6 and a dividend yield of 6.2%." The next day, August 25, brought news that private investors were filling their boots with Northern Rock stock, as well.

"Last week and the end of the week before were the busiest time we've seen since February/March this year," the FT learnt from Alison Cashmore at TD Waterhouse. Trading volumes increased by more than 50%, she said, with private investors "focusing particularly on banking stocks."

The top five purchases for lumpen schmucks in August? Barclays, Royal Bank of Scotland, Northern Rock, Lloyds and British Airways.

"Clients seem to have taken the market weakness as a buying opportunity," the woman from TD Waterhouse noted. "They are treating it as a short-term blip and we certainly have not seen any panic selling from retail investors."

Since then, Northern Rock's stock has slumped to stand 52% lower from mid-June. It's down by nearly two-thirds from its all-time top of February. And what kind of collateral is the Bank of England going to accept from Northern Rock as it steps in as lender of last resort?

"The repurchase facilities would include securities that have prime residential mortgage assets as underlying collateral," says the borrower. Which is handy, right? Northern Rock has got a bunch of those lying around...some £20 billion more in July than it had in January, in fact.

Regards

Adrian Ash
For The Daily Reckoning

Adrian Ash is head of research at BullionVault.com the world's fastest-growing and best-value gold ownership service.

http://www.bullionvault.com/from/dailyreckon