Northern Rock: Narrative
Northern Rock – History
- Northern Rock began in the nineteenth century as a mutually owned “building society”, with a business focused on serving its local community.
- The bank went public in 1997 and grew at an annual rate over 20 percent for the next ten years, with total assets of 113.5 billion pounds, the fifth largest U.K. bank by mortgage assets, as of June 2007.
- Northern Rock focused on prime lending, had minimal subprime exposure, and the U.K. housing market remained strong in the summer of 2007.
- But rapid growth starting in 1997 outstripped the traditional deposit base, and the bank had to rely on non-traditional funding sources.
Repo – 2007
- Over the summer of 2007, some of these nontraditional funding sources began to dry up, and efforts to organize a private rescue for the bank failed.
- On 9/13/07, the BBC broke the news that Northern Rock had sought assistance from the Bank of England; the BoE granted that assistance the next morning. The run on retail-branch deposits began that day.
- At the time of the run, full deposit insurance in the U.K. was capped at 2000 pounds, and then 90 percent up to 35,000 pounds.
- Despite the public nature of the retail-branch run, the real story was a wholesale run that had intensified in the previous month.
Northern Rock – The Puzzle
“The real question raised by the Northern Rock episode is not so much why retail depositors are so prone to loss of confidence that lead to bank runs, but instead …
why sophisticated lenders who operate in the capital markets chose suddenly to deny lending to a bank that had an apparently solid asset book and virtually no subprime lending.”
Northern Rock and the Global Financial Crisis
The “Monolines” – Background
- Since they began in the 1970s, bond insurers main business was to provide credit enhancement to municipal bond offerings.
- This insurance was provided by specialized companies that do not sell other types of insurance products – hence the name “monolines”.
- In the roaring 2000s, they expanded into insurance provision for structured products (securitizations and CDOs).
- January 2008, MBIA and Ambac (the two largest insurers), had a combined $265 billion in structured-product guarantees.
- Starting in mid-2007, the markets became worried about these insurers.
Source: FCIC, p. 276
Auction Rate Securities – Background
- The traditional way to sell securities is with a primary offering, followed by the management of a secondary market. For some types of securities, the secondary markets are so illiquid that investors are scared away.
- Auction rate securities (ARS) are a solution to this illiquidity, with a broker-dealer holding periodic auctions of long-term bonds to reset the interest rates based on demand.
- Historically, broker-dealers reputational concerns meant that they provided a backstop to the market, holding paper to manage shortterm liquidity disruptions.
- ARS are used for a very quiet type of securities: mostly studentloan pools and municipals.
- The municipal securities were given credit enhancement by the monolines … uh-oh.
- In mid-2007, Bear Stearns was the fifth-largest investment bank in the United States, with assets of about $400 billion.
- The firm was a significant player in all parts of the subprime space, from loan origination to trading.
- The first problem occurred in June 2007, with a suspension of redemptions in two Bear-managed hedge funds.
- For reputational reasons, Bear bailed out these funds after liquidation on 7/31 by paying off their lenders and taking the collateral onto its own balance sheet.
- This action, and the losses from other asset holdings, were not nearly enough to drive Bear Stearns into insolvency. So what happened?
What happened? A remarkable combination of liquidity pressures that took virtually everyone by surprise.
- Prime brokerage withdrawals
- “Novations” of derivatives
- Collateral calls
- Maturity shortening on secured “repo” loans
- And, finally, a run on repo
- The Federal Reserve supported a JP Morgan buyout of Bear Stearns, initially set at $2 per share, later raised to $10.
- After Bear Stearns policymakers introduced several new tools to support liquidity in interbank markets.
- The markets did not learn their lesson. The failure of Lehman Brothers six months later followed a similar script.
- Some argue that Fed actions during the Bear Stearns crisis created a false sense of complacency and belief that there would always be support for other “too-big-to-fail” institutions – a belief that proved false and damaging before Lehman.
- An alternative explanation is that these wholesale banking operations were inherently fragile – in ways that were simply not understood at the time – and our regulatory system was not equipped to handle their rapid failure.
- Institutions with subprime exposures began to fail in early to mid 2007.
- These failures were not expected to be a problem for broader economy, but led to stresses in wholesale funding markets, notably the ABCP market.
- These tensions would contribute to failures of seemingly unrelated or sufficiently insulted firms and markets: Northern Rock, auction rate securities and Bear Stearns.
- The vulnerabilities were not fixed, and there would be worse problems to come.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
Goldman Sachs & Co., a unit of the most profitable bank in Wall Street history, took $15 billion from the U.S. Federal Reserve on Dec. 9, 2008, the biggest single loan from a lending program whose details have been secret until today.
The program, which peaked at $80 billion in loans outstanding, was known as the Fed’s single-tranche open-market operations, or ST OMO. It made 28-day loans to units of 19 banks between March 7, 2008, and Dec. 30, 2008. Bloomberg reported on ST OMO in May, after the Fed released incomplete records on the program. In response to a subsequent Freedom of Information Act request for details, the central bank disclosed borrower names, amounts borrowed and interest rates.
ST OMO is the last known Fed crisis lending program to have its details made public. The central bank resisted previous FOIA requests on emergency lending for more than two years, disclosing details in March of its oldest loan facility, the discount window, only after the U.S. Supreme Court ruled it had to. When Congress mandated the December 2010 release of data on special initiatives the Fed created in its unprecedented $3.5 trillion response to the 2007-2009 collapse in credit markets, ST OMO — an expansion of a longstanding program — wasn’t included.
“The Fed has come a long way over a long period of time as far as transparency,” said Raymond W. Stone, managing director and economist with Stone & McCarthy Research Associates in Princeton, New Jersey. “They thought counterparties might be harmed, but now so much time has passed that the information is not as sensitive anymore.”
The 19 borrowers from the program are known as primary dealers, which are designated to trade government securities directly with Federal Reserve Bank of New York. They bid at auctions for ST OMO’s cash. While the rates they paid generally tracked the federal funds rate, the rate for some dipped as low as 0.01 percent in December 2008.
The New York Fed conducted 44 ST OMO auctions, according to its website. Banks bid the interest rate they were willing to pay for the loans and pledged mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae or Freddie Mac as collateral for the Fed’s cash. The transactions were known as repurchase agreements, or repos.
ST OMO was an expansion of longstanding open-market operations, which offered cash for up to two weeks and were used as a tool of monetary policy. In March 2008, the Fed adapted the program to alleviate pressures in short-term credit markets, according to a news release the central bank issued at the time.
The program shouldn’t be grouped with the Fed’s other crisis lending initiatives because it was “not outside of the Fed’s standard authorities,” David E. Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta, said in his blog in May.
The New York Fed posted aggregate data about the program on its website after each auction, said Jeffrey Smith, a New York Fed spokesman. By increasing the availability of short-term financing when private lenders were under pressure, “this program helped alleviate strains in financial markets and support the flow of credit to U.S. households and businesses,” he said. All of the ST OMO loans were repaid.
Some primary dealers used the program to help customers, such as hedge funds, finance their holdings of mortgage-backed securities, Stone said.
“The Fed didn’t want to just finance the primary dealers, they wanted the mortgage-backed securities market to become more fluid,” Stone said.
Credit Suisse Securities USA LLC, a unit of Switzerland’s second-biggest bank, had $45 billion in loans outstanding on Aug. 27, 2008 — the largest peak borrowing amount, the data show.
“Credit Suisse was a net creditor throughout the crisis and made between $30 and $70 billion of liquidity available to central banks each day,” said Victoria Harmon, a spokeswoman for the bank in New York.
Six of the program’s top seven borrowers were units of foreign banks, the data show.
Goldman Sachs’s peak outstanding loans were the second- highest at $34.5 billion on Dec. 31, 2008, when interest rates were at their lowest, according to the data. Michael DuVally, a spokesman for New York-based Goldman Sachs Group Inc. (GS), the parent company of the primary dealer, declined to comment.
Lehman Brothers Inc. had two loans totaling $2 billion outstanding when its parent investment bank filed the biggest bankruptcy in U.S. history on Sept. 15, 2008, the data show. Those loans were repaid on Sept. 18, 2008, under a separate agreement, the Fed’s release said. Lehman’s peak borrowings from ST OMO reached $18 billion on June 25, 2008, according to the data.
Kimberly Macleod, a Lehman spokeswoman, didn’t immediately respond to an e-mail seeking comment.
RBS Securities Inc., a unit of Britain’s second-biggest bank by market capitalization, had $31.5 billion in loans outstanding on Oct. 8, 2008, and UBS Securities LLC, part of Switzerland’s biggest bank, borrowed as much as $20.5 billion on Nov. 26, 2008, the Fed said.
Among the smallest loans was one to Bear Stearns & Co., the primary-dealer unit of Bear Stearns Cos. The primary dealer took one loan from ST OMO for $500 million, on March 12, 2008, according to the release. JPMorgan Chase & Co. (JPM) bought the New York-based investment bank four days later. The loan was repaid on April 9, 2008, the data show.
The information on ST OMO is available on the central bank’s Web site: http://www.federalreserve.gov/monetarypolicy/bst_tranche.htm