Northern Rock and the law of unintended consequences

29 September 2009

Perhaps it’s a coincidence but in the year that we are celebrating the 150th anniversary of the publication of the Origins of the Species there are still question marks over the future of Northern Rock which in Darwinian terms should have gone the way of the dinosaur back in 2007.

That’s when its business model, which had become over dependent on wholesale funding, failed. The markets in which it operated changed and its vulnerability was compounded by the Basle II regime. This allowed it to reduce its capital as its exposure to the mortgage market increased dramatically.

But instead of being consigned to history the Rock was nationalised as a short term political expedient and now, with managing director Gary Hoffman beginning to turn the business around, the expectation is that it is likely to be sold off again ahead of the forthcoming general election.

However, re-engineering this dinosaur for ironically what might be defined as a post-Rock age is proving problematical and much depends on splitting the business into a good bank/bad bank model with the bad assets being held in limbo and the good bits being sold to the private sector.

That restructuring is on going and the final package will have to receive EC approval but even so the Building Societies Association has already registered an interest. This comes in the form of a report by the Centre for Mutual and Employee-owned Business and urges the government to seriously consider returning the Rock, a building society until 1997, to the mutual fold.

That may seem odd given that some BSA members have also been imitating the Rock and have been ‘Nationwidelised’. That’s the mutual lenders’ equivalent of being nationalised, though their problems had little to do with funding and everything thing to do with adventures into commercial lending and ill-advised mortgage book investments.

Others have also recorded losses but are still hanging on in, so the jury must be out on the report’s argument that we’d be better off with the Rock as a mutual because “their objective is safety and fair pricing for members, not profit extraction for shareholders”.

That said there’s value in the report’s case for having a financial sector supported by a diversity of institutions. It refers to this as 'bio-diversity' (back to Darwin again), and argues: “A financial system with diverse ownership and governance structures is better able to weather the strains of the business cycle than one which is plc-dominated”.

So are societies going to chip in to capitalise a Northern Rock Building Society and pay back the tax payer? Well not exactly - the preferred route is profit participating deferred shares which would allow capital to be provided in a way that carries modest servicing costs to begin with but which might deliver a fair overall return in the long term.

The report acknowledges that the Rock as a mutual would be a relatively low-risk, low-return business, especially if it is required to make future payments to the taxpayer. Even so, it asserts that remutualisation “could be expected to generate an advantage to the taxpayer over the long run in excess of the immediate benefit of any capital proceeds in the short term”.

That could amount to jam three days after tomorrow, given the pressure that the financial Services Authority is currently putting on building societies to hold higher levels of capital and liquidity. There’s even a proposal in the Mortgage Source Book to impose lending limits.

As Michael Coogan, director general of the Council of Mortgage Lenders, points out in next month’s Lending Strategy, many societies will have lent more than they would be allowed under the proposed source book model. “They’ll have to reorganise their books to de-risk”, he says. “At a time when you’re trying to get more firms lending, trying to get established lenders to shrink their books won’t help. It won’t help economic activity, it won’t help competition.”

On the other hand, the Rock will have de-risked it books by the time it goes to market, and as born again building society, it might well have a competitive advantage and one wonders what the rest of the sector would have to say about that!