City war game that ended in a battle to save Northern Rock

City war game that ended in a battle to save Northern Rock
Guardian Unlimited, UK –
For the past three years, the Bank of England, the Bank for International Settlements and the International Monetary Fund have warned that markets misprice risk, with investments that would once have been seen as high risk yielding little more than rock-solid government bonds.

The warnings went unheeded; markets were on the up and it was believed that innovations allowed risk to be parcelled up and farmed out to a multitude of investors. This theory was tested with the mortgages offered in the United States to borrowers with less than glowing track records. Tested to destruction, as it turned out.

Northern Rock was busy raising funds on the wholesale money markets as far back as 1999, not long after the former building society demutualised.

With few branches and relatively few depositors, the bank lacked the savings its rivals relied on. By 2006 it was parcelling up £5bn of mortgage loans every three months and selling them through a complex offshore operation it called Granite.

In January the bank began lending at breakneck speed. With interest rates at historic lows, everyone was. In particular, some of the smartest people in the City, working in private equity, were raising billions for their buyout deals.

Other banks such as Halifax followed the same path. At the time of the Northern Rock crash it had several billion pounds of mortgages in trusts in Jersey. However, unlike Northern Rock, mortgages account for only about a fifth of its profits. Far from specialising, as Northern Rock has done since its demutualisation, Halifax had diversified. That, as the FSA and the Bank recognise, was a crucial difference. Northern Rock copied the big boys but had all its eggs in one basket.

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