Northern Rock: A Case in Low Frequency High Impact Event

In 2007 Northern Rock experienced a bank run, the first since 1886 by its depositors. The bank saw a withdrawal of 3 billion pounds which constituted about 11% of Northern Rock’s retail assets. It had to ask the Bank of England to intervene to save it. It eventually was taken over by Bank of England and later Virgin money.

Northern Rock was originally a mutual building society. It became a bank in 1997. Northern Rock could therefore move into all areas of banking. It chose to however focus on the residential mortgage business. Its strategy revolved around securitization and funding, and it used mortgage backed securities, extensively.

Problems in the MBS market in the US, resulted in a loss of faith by depositors. Despite assurances from The Bank of England, the UK’s Financial Services Authority (FSA) and Treasury (the UK government’s finance office) that Northern Rock was indeed solvent, the run could not be contained.

It may be considered irrational that depositors decided to do this, but global developments in this market make it less so.

Northern Rock used securitization quite extensively. This involved the bank collating its loans such as mortgages into one package. This portfolio was then sold to the capital market. The mortgage portfolio is usually bought by other financial institutions or Special Purpose Vehicles, Structured Investment Vehicles (SIVs), or Conduits of Northern rock. The buyers then sold them as securities, rated according to the mortgage underlying them. In this way Northern Rock passed on the loan to other agencies through SPVs extending them a line of credit in the event that they fell short of money to renew the securities.

The subprime market in the US was growing rapidly, with mortgage loans being combined with Collateralized Debt obligations (CDOs). The rating agencies usually gave CDOs high rating on account of the low number of low risk loans within it. Buyers of MBS and CDO’s included hedge funds, banks the world over or conduits established by banks or special purpose vehicles (SPV).

When housing prices started to crash, these buyers were affected. These banks, including Northern Rock started facing liquidity constraints. Further, a rise in the cost of funding meant it became increasingly difficult to roll-over short-term debt issues. Liquidity in the inter-bank market became worse resulting in a tier based interest rate system.

Banks with exposures to the MBS market started to feel the pinch. Most of their capital was tied up with mortgage assets and it looked unlikely that they could offload it to the MBS market. The liquidity crunch also meant that they could not continue to give credit to their SPVs. The market uncertainity resulted in some of the following issues: