Journal Alioth's Journal: The Northern Rock paradox 1
So, after Northern Rock bank announced it needed an emergency loan from the Bank of England to sort out its cashflow problems, depositors have been clamouring to withdraw money from their accounts (some with substantial amounts of money - the BBC interviewed one customer who had just withdrawn £150,000 (US$300,000)).
Apparently, in a single day, depositors withdrew £1bn from the bank. (The bank has around £24bn in deposits total). Today, it's still going on - customers are lining up down the street to withdraw their savings.
The bank itself is solvent and profitable - but it's been hit by the credit crunch because it obtains the money to lend for mortgages from the money markets, rather than loaning from deposits on hand (most high street banks in Britain do it the "old fashioned way", lending from money they have on hand in deposits). If you even take the briefest look at the bank, you'll find that it's really in no danger of going tits up. Well, if people don't withdraw all the money and make their predicament even worse (and even so, now they have the backing of the Bank of England).
So onto the paradox. Had customers listened, and held their nerve, and not queued up in huge lines outside Northern Rock branches to take all their money out - Northern Rock would likely have done just fine. They haven't actually drawn down a loan from the Bank of England yet, they just now have that option to ensure they don't go tits up if they can't get the money they need off the markets.
But now that people are panicking and rushing to take all their money out, the customers who are sure the bank is going down are creating a self-fulfilling prophecy. (I wonder if the traditional branch deposit customers, who represent about £5bn of Northern Rock's deposits - will have totally emptied the lot by next Friday?).
If you were an otherwise non-panicked Northern Rock depositor, what do you do?
Imagine you are a "non panicky Northern Rock depositor".
Now that there's a run on the bank, you almost are compelled to make the situation worse - because the panic is draining the life-giving cashflow from the bank, which is already stretched (that's why it asked the BoE for a loan in the first place) - although you may know that taking out your hundred grand's worth of deposit will just make Northern Rock's situation worse, you're almost compelled to do it - because everyone else is doing it, and if you don't, well - when the Rock goes tits up you lose everything.
So we now have a vicious feedback mechanism - where even the sane must follow the sheep or they have a significantly nonzero chance of losing their deposits (only the first £2000 is entirely safe, so big depositors will feel seriously exposed). The original problem won't be what kills Northern Rock, the vicious feedback that arose as a consequence will kill it. (The bank may not collapse - after all, they can cover themselves with the Bank of England loan, but once the depositors are gone, the bank is forced to use that loan, it isn't really viable any more as an independent entity, and the mortgage books will be bought by another bank. The mortgage books are apparently reasaonbly good quality - Northern Rock itself does not engage in sub prime lending, it only acts as an agent for another financial institution for that kind of lending. Although some of the "prime" mortgages that it does have would be considered "sub-prime" in the United States).
The other funny thing is how many people are acting all surprised about the whole credit crunch. I could have told you a year ago that bad stuff was going to happen sooner rather than later. (I remember having to resist the urge to yell at the radio as a bank started lending really stupid amounts of money to first time buyers "to make it easier to afford a first time buyer's house". The bank's executive who was being interviewed on the Today Programme was making some vacuous statements about how they were trying to solve the problem of affordability for first time buyers, as if they were doing us all a favour. Don't they understand the laws of supply and demand? Loaning out more money than is sane will just keep demand for new houses high, while not doing anything for supply - result, house prices continue to soar - so all they were doing was feeding this positive feedback loop that was inflating the bubble. They knew it, too - but the old greed bandwagon was well under way. You can milk a lot from a customer with an interest-only mortgage). Why is anyone surprised when people are mortgaged to the hilt because the banks just couldn't say "no", and are now living paycheck to paycheck, that when interest rates go up quarter of a percent they can no longer meet their loan obligations and start defaulting?
Everyone's going on about the US sub-prime problem, but that's just merely the trigger. The problem is a little different here - the huge overvaluation of property is just due a massive correction - house price inflation of over 20% a year is just not sustainable even in the short run, let alone the long run. The gravy train was going to smash into the buffers sooner rather than later, and we were just waiting for the trigger. The trigger just happens to be the credit crunch - it could quite easily have been a number of other things (a sharp increase in oil prices could have done it, or a sharp increase in the price of food, council tax rises - anything like that), given the number of people who are so horribly exposed due to being lent so much money for mortgages that they were barely getting by. Is there really no one who couldn't see this coming?
Perhaps a return to the usual formula of 3 times annual income for mortgage lending, rather than the hugely optimistic affordability calculations some banks have been doing in their desperate clamour to lend people money will bring some sanity back to the housing market.
The plan (Score:2)