The Northern Rock Debacle and More to Come?

Lifeboats, Nationalisation, Moral Hazard and Free Market Economics

London, UK - 18th February 2008, 08:36 GMT

Dear Open ATCA & Philanthropia Friends

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The UK finance minister, Chancellor Alistair Darling, is due to put forward emergency legislation in Parliament to nationalise Northern Rock, the infamous "non-bank" bank, which became the picture poster victim of the global credit crunch in September 2007. Northern Rock suffered the first run on a British bank in 140 years.

Sunday's surprise announcement means the bank's estimated GBP 55+ billion (USD 108+ bn) in liabilities will be placed in the public's lap. The British taxpayer's relationship with Northern Rock has evolved in the last six months from creditor to guarantor to owner! This will be the first lifeboat-nationalisation solution of its kind in nearly 35 years. The Opposition led by the Conservative Party has said the move to public ownership marks the death of the government's reputation for economic competence. However, the Liberal Democrats said the government had made the right decision, "belatedly". Mr Darling has insisted that it was the best way to safeguard people's money. The decision has infuriated Northern Rock shareholders and shocked the remaining two private bidders vying for the stricken mortgage lender.

In parallel, the UK current account deficit reached 5.7% of GDP in the third quarter of last year, the worst of any major country in the world, bar Spain. Further, the household sector is borrowing at an unprecedented 4% of GDP. Basing economic growth on unsustainable asset price bubbles may yet prove to be a recipe for protracted trouble. With a budget deficit of 3% of GDP at the top of the cycle, the UK enters the slump without a fiscal shield. For those who remember Euro-land rules, this deficit is beyond the legal limit of the Maastricht Treaty. The government share of GDP has risen from 37% to 45% in eight years based on OECD figures and now exceeds that of Germany for the first time since the 1970s.

The emergency lifeboat public loans designed to keep Northern Rock afloat until a private-sector solution could be found totalled at least GBP 25 billion (USD 49 bn), yet no credible offers for the bank emerged. Interest among private-sector bidders waned since the gigantic loans were first revealed in September. That is in part because of market conditions more generally and in part because the loans, and the government's insistence that they be repaid post-haste, became an anchor that no private lifeboat could, would or should bear. The Northern Rock debacle may tarnish the UK's reputation for excellence in banking and may be perceived to be a symbol of massive regulatory failure. Britain claims to be the world's pre-eminent financial centre and yet has been forced to nationalise a mortgage bank. This is a paradox!

The government may have made the right basic decision, but it is several months too late and unrealistic in its plan to run the bank as a normal commercial operation. Northern Rock may not just have to be nationalised but its doors to future business may have to be eventually shut otherwise its continued existence may fundamentally distort the UK mortgage market as a whole. Sir Richard Branson, whose Virgin Group was a bidder, said he was disappointed by the decision, "We believe nationalisation is not the right answer and that a commercial solution would have been the best way forward."

The vast pools of easy short-term credit on which Northern Rock's non-bank business model was built are not likely to return anytime soon, if ever. Using the public purse to put the Rock in a position of strength versus other banks that have been battered by the subprime crisis but did not ask taxpayers to bail them out may be a travesty and completely against the principles of free market economics. Not to talk about the attendant moral hazard and the strong interventionist signal which it sends out to the global financial markets. The second disturbing message that nationalisation sends out is that any financial institution which mismanages itself will be saved by the government. This is the "moral hazard" that Prof Mervyn King, the Governor of the Bank of England, has warned about repeatedly since the crisis started. It may encourage some banks to be more reckless but that is unfair on their prudent counterparts and sets a negative precedent.

[ENDS]