Repost: My Onetime Notes On Northern Rock

This is a ship service I made fairly early on inwards the history of the spider web log - in addition to a ship service I think should take hold got to a greater extent than attention. (The original post had no comments in addition to nobody much link to it.) I re-read it today (because it came upward inwards conversation). I am sort of proud of it - so allow me the luxury of a repost.

Reposted

In 2005 I travelled to the UK to study the UK banks. I should take hold shorted the lot of them. But I didn’t. But for the tape hither are my notes – written on a tiresome English linguistic communication develop – nigh Northern Rock – in addition to never finished. I take hold edited it exclusively to take references to my actual sources.

I set this upward non to gloat (but its nice). Rather I am going to practise an expose of to a greater extent than or less other U.K. banking concern shortly.

I cannot gloat likewise much - because whilst these notes are amazingly prescient I did non brand a fortune on the stock. I predicted pelting - but its making an ark that counts!

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Northern Rock – leverage mortgages to the max

Northern Rock is a real uncomplicated bank. It has exclusively i strategy in addition to it makes no bones nigh taking this strategy to its absolute limit. They are completely non-forthcoming nigh where the bound of this strategy mightiness last – but nosotros volition come across that later.

The strategy of Northern Rock is to grow the mortgage book. Fast. All reject inwards margin is to last made upward past times volume growth. They are absolutely explicit nigh this – the corporate objective is:

• Grow the property base of operations past times 25 per cent per annum addition or minus 5 per cent
• Grow earnings past times xv per cent per annum addition or minus 5 per cent.

It is pretty clear that they take hold fifty-fifty de-emphasized the one-time edifice lodge funding base of operations which is I think mightiness last truly shrinking earlier “hot money” high charge per unit of measurement deposits in addition to unusual deposits[1]. At the conference they told us how they were silent concentrating on the deposit base of operations but it had the tone of protesting likewise much. Besides its clear that rating agencies in addition to bond markets desire to a greater extent than or less deposit based liquidity.

I am also non exaggerating inwards the slightest nigh what the corporate strategy truly is. The management must take hold used these ii bullet points 5 times inwards my presence (and I was non amongst them long).

Well it is pretty clear that growing the residue canvass past times 25 per cent per annum grows peril past times something nigh 25 per cent per annum (the society volition deny this – to a greater extent than on that later). Growing profits past times xv per cent per annum way that upper-case missive of the alphabet volition air current upward growing past times xv per cent per annum (give or take hold a little).

If you lot grow peril past times 25 per cent in addition to profits in addition to upper-case missive of the alphabet past times xv so either

• You volition run out of upper-case missive of the alphabet in addition to the regulators or rating agencies or bond markets volition non allow you lot to fund your growth – inwards which illustration the growth fizzles out at best, or
• You volition eventually last taking so much peril that the supply on upper-case missive of the alphabet volition non last rational inwards an ex-ante basis. Some indicate ex ship service you lot volition blow up, peradventure spectacularly.

If you lot think I am exaggerating what this strategy is so hither are the 5 twelvemonth summary numbers from the annual report. Ten twelvemonth numbers were reported at the conference in addition to they had pretty good the same appearance.

INSERT [sorry I wrote this on the develop in addition to had a hard re-create of the annual. I never bothered putting the actual tabular array from the soft re-create inwards the report]

Note in that location is no credit information here. Nowadays credit losses are negligible in UK mortgage banking.

Obviously you lot should respect the massive expansion of leverage inwards this book. The property number to facial expression at is the “total assets nether management”. This number includes securitised mortgages where the residual credit peril is at Northern Rock. (The principal buyer of this newspaper are Japanese banks both major in addition to regional.[2]) The full leverage of volume has moved from 27 times to 42 times. Obviously this can’t become upward for ever but I suspect it tin strength out become for quite to a greater extent than or less to a greater extent than time. (You volition come across that 43 times leverage is non unusual for a U.K. bank.)[3]

When I was amongst the society I tried to explore the limits to the strategy in addition to got nowhere useful. It would last overnice to know though because when the society reaches the bound of its leverage it would last a security curt (unable to grow in addition to peradventure facing farther margin erosion). Until so its in all probability a meliorate long so a curt every bit in that location seems no impediment to earnings increasing at at to the lowest degree the teens in addition to the PE is exclusively XXX now.

That said – hither goes for my news nigh the limits to Northern Rock’s growth. The society told everyone at the conference that mortgages were safer than conventional loans in all probability deserving a 33 per cent peril weighting. In Australia and the US the measure is 50 per cent peril weighting for mortgages amongst no insurance less than fourscore per cent loan to value (LTV ratio) so past times international standards 33 per cent is aggressive.[4] That said Northern Rock suggested that in that location mortgages were substantially safer than the average (measured delinquency at nigh one-half the marketplace rate) in addition to hence they should take hold one-half the peril weighting – telephone yell upward it 17 per cent. They fifty-fifty went every bit far every bit to tell that the regulator agreed amongst them. [Some comments take hold been removed hither because they study indirect comments from regulators.  I cannot vouch for them on this blog.]

Now if your mortgages require exclusively a 17 per cent peril weighting so you lot tin strength out last 84 times levered amongst a Tier One ration of vii per cent. [Figures: 1/(.17*.07)]. If a 3rd of your tier i upper-case missive of the alphabet is subordinated debt (not uncommon inwards banking these days particularly inwards the UK) so your full leverage ratio mightiness last good over 100. I did this calculation for them in addition to they were quite uncomfortable – because they are hardly wanting to telegraph to the rating agency that they volition i twenty-four hr menstruum last 100 times levered. (It would increase the toll of their funds straightaway in addition to hence farther compress their margin.)

I did non larn whatever useful feed on where the limits to growth are. However looking at the other banks (discussion later) I suspect that the bound is roughly 60 times levered. That would propose (growing upper-case missive of the alphabet at xv in addition to earnings assets at 25) that in that location are 4 to 5 years left. However past times that indicate the banking concern has almost ₤200 billion inwards assets – large compared to the UK mortgage market. Its funding would last totally ridiculous. [Comment deleted because a senior executive of to a greater extent than or less other U.K. banking concern sentiment Northern Rock would become bust inwards 2007. I exactly practise non desire to dump him inwards it.] Something volition cleft – but inwards 5 years earnings could double i time to a greater extent than in addition to the stock could last an abysmal short.

If you lot facial expression at the 5 twelvemonth summary inwards a higher house you lot volition respect that the mortgage originations inwards whatever twelvemonth the gross lending is substantially larger than the internet lending. In 2004 gross lending was GBP23 billion - nigh 45 per cent of the full managed volume at the terminate of 2003. Asset growth is exclusively nigh 45 per cent of internet lending.

This leads into the way that the lending is done. Its TEASER RATE lending. In the UK new mortgages (especially from this bank) tend to take hold a “teaser rate” which applies for ii to 3 years (mostly ii years). The fashion of belatedly is to take hold ii twelvemonth fixed charge per unit of measurement loans on real depression spreads (the yield bend is apartment inwards the UK) in addition to to outset the spread a niggling fleck inwards up-front fees. The loans revert to one-time fashioned (and fatty margin) measure variable charge per unit of measurement (SVR) at the terminate of the teaser charge per unit of measurement period. The profitability of this concern is determined past times how many of the loans you lot contend to maintain on your books after the teaser charge per unit of measurement wears off in addition to on whatever incidental products you lot mightiness sell to the mortgage holder. If the loan comes inwards through a branch rather than an IFA the loan mightiness last to a greater extent than profitable because it does non crusade a broker fee.Internet channels are also relatively profitable.

The way that Northern Rock grows so fast is that it is the manlike somebody monarch of the teaser rate. It has withal real wretched retention. Bradford in addition to Bingley told me that Northern Rock would boast nigh their 400 memory staff (they volition cutting your charge per unit of measurement if you lot band upward because the alternative is for you lot to become elsewhere in addition to a cutting charge per unit of measurement loan is to a greater extent than profitable than a novel brokered loan). The contest also target Northern Rock customers. Natwest (HBOS) take hold regular advertisements on TV showing people on a rollercoaster amongst real depression mortgage rates nigh to swing upward wildly (and quite graphically brand them sick). They propose that you lot are nuts if you lot take hold this swing upward in addition to offering you lot GBP100 if you lot are an Alliance & Leicester or Northern Rock client (not a B&B customer) in addition to your rates refinance in addition to you lot practise non desire to choice a Natwest mortgage. Its clear that Natwest withal is trying to larn people through the (lower cost) straight channels. (This sort of contest exists inwards deposit pricing too.)

There is a exam every bit to whether all this teaser charge per unit of measurement activeness produces long term customers. Just facial expression at the implied autumn off inwards loans versus the originations ii years ago. In 2004 it appears that over GBP10 billion repaid. Gross lending ii years agone was 12.5. There is clearly some but quite limited success inwards retaining the customers. When pushed on accurate information on this number Northern Rock were only non forthcoming.

There is i to a greater extent than affair that is quite revealing nigh Northern Rock – in addition to that is the trial of International Accounting Standards (IFRS) on residue canvass in addition to profitability. UK companies are beingness forced to adopt IFRS in addition to whilst it is an number amongst a lot of dissonance for many companies the differences are small. They are non modest at the Rock. In detail IFRS requires that income in addition to expense charged every bit a fee but which relates to to a greater extent than or less menstruum gets amortised over the period. Now recollect that the shift inwards the marketplace has been from floating charge per unit of measurement teaser products to fixed charge per unit of measurement teaser products amongst high fees. The Rock has been booking those fees upward front end inflating earnings in addition to volume value. IFRS volition (under the guidance given at the conference) trim back volume value in addition to earnings past times nigh 10 per cent. (Leverage is in all probability closer to 47 times – in addition to using a 60 times bound the society in all probability has exclusively 3 years rather than five.) The society seems to think that IFRS is a bad sentiment (aren’t the fees cash). But I am never quite certain whether the mix of fees in addition to spread has shifted driven past times accounting considerations or whether its driven past times the realisation that churn is going to rest incurably bad or larn worse. (Obviously plenty upward front end fees are a proficient sentiment if you lot are scared of churn.)

All of this was plenty to brand me pretty bearish on the stock. But it got worse. They only stretched numbers to tell what they practise not. If it were non for the depression standards of America I would tell they lied – but I suspect exactly beingness economical amongst the truth was closer. I take hold referred inwards a higher house to the notion that their delinquency is one-half the manufacture average in addition to hence (as they argue) they deserve exclusively one-half the regulatory upper-case missive of the alphabet charges of the competition. The employment is that a delinquency charge per unit of measurement only does non brand feel when your growth has been every bit rapid every bit the Rock. I tried to tease out of them the notion of a “growth adjusted delinquency rate”. No luck. I tried to go out what the delinquency past times historic menstruum of mortgage was so I could practise the numbers – no luck. They only were non forthcoming in addition to fifty-fifty attempted to mislead me.[5]

The house withal they misled most blatantly was on the margins both historic in addition to prospective. The society stressed that I should non exactly facial expression at involvement margin – rather I should facial expression at fees addition margin over assets – particularly every bit they had shifted to fixed charge per unit of measurement depression margin loans amongst relatively high fees.Ignoring the IFRS number (as they did) the average margin on the volume is 125bp in addition to it has fallen every twelvemonth – most notably during 2004. They wanted to order me that the INCREMENTAL margin was 110-120bp. This is much higher than the contest order me the margin is (40-80bps) in addition to only cannot last squared amongst the margin figures inwards the inwards a higher house table. The employment is that they volition before long hitting bound leverage constraints (but they would non order me what those constraints were) in addition to were aware that their margins (hence earnings in addition to ROE) would proceed to drib i time they hitting those limits.

As for credit risk. The society told me that they had a seat inwards the broker marketplace every bit offering the cheapest loans to the best credit. I take hold i ground to disbelieve them. The Rock has a lower rating in addition to hence a higher funding toll than several competitors – in addition to hence would naturally take hold a relative wages farther upward the peril spectrum (its hard to practise proficient credit good amongst a depression rating). Also they told me inwards to a greater extent than or less other breath that they had manufacture leading margins (which did non reverberate inwards the accounts).Stuffed if I know. They seem to think that they volition last alright amongst a 20 per cent autumn inwards the belongings market. They seem to larn concerned when you lot speak nigh a xxx per cent autumn – in addition to they seem to think that a 35 per cent autumn is impossible. I heard all the one-time hoary clichés: “they are non making whatever to a greater extent than set down inwards the South East” etc. I should larn the stock brokers to organise me to a greater extent than or less chats amongst mortgage brokers in addition to IFAs. But I am – until that – inclined to believe that the threshold for hurting is nigh a xxx per cent autumn inwards the belongings marketplace – in addition to that falls beyond this hit could Pb to a wipe-out because the loan volume is novel (hence has non had the peril to larn much appreciation into it) in addition to is so levered. [Ok – I was incorrect hither – they went bust on funding.]

You practise take hold to give the banking concern credit for i affair though. They take hold got their costs quite depression – 38bp of assets in addition to in all probability lower nether IFRS. This is i of the lowest toll structures inwards the world. The management volition indicate this out every bit almost their crowning achievement. They had to practise it (had they kept their one-time toll construction the crush inwards margins would take hold wiped them out). It does withal facial expression hard to maintain reporting lower costs – this looks a lean operation.

Do I desire to curt it? I wouldn’t object – but I suspect nosotros tin strength out practise meliorate amongst timing. The investment bankers are convinced that if something went incorrect it would last purchased at fourscore per cent of volume on the way down. Maybe that is truthful straightaway – but it volition non ever last so. I was staggered past times the lack of sophistication of the staff – I met the CFO in addition to he was either dumb or a liar or exactly assumed I was dumb.This society is totally subject on the goodwill of fiscal markets. I set to them that they were subject on the kindness of strangers – in addition to they bristled. They sentiment that people invested in UK mortgages because they were proficient investments. Why – so they sentiment would you lot invest in Italy?

For discussion.

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[1] The shrinkage does non exhibit inwards the numbers – but the deposit base of operations includes €2.5 billion in French deposits which are truly hot-money commercial newspaper in addition to to a greater extent than or less Japanese deposits. The claimed retail deposits inwards the 5 twelvemonth results page I reproduce (17239) does non tally the residue canvass (20342) in addition to I am assuming the divergence is roughly the inwards a higher house €2.5 billion in addition to other quasi wholesale money. I can’t order how much “hot money” in that location is but Northern Rock were pretty cracking to advertise a 5.4 per cent rate.The shrinkage is a estimate – but the society was non far from admitting the same when pushed on the issue.

[2] Amazingly the CFO was prepared to shout out the vi Japanese banks which purchased the paper. I told him nosotros had an involvement inwards the Japanese banks in addition to it would aid me empathise their books. He did non recollect their names but he had been on a roadshow to Japan. I take hold virtually never had a society volunteer this sort of information. Its pretty naïve to practise so every bit in that location is to a greater extent than than i way to interfere amongst a banks funding. If he had sentiment nigh it clearly it was exactly every bit probable I was curt Northern Rock than long it. It was purpose of a full general mental attitude I came across in Britain (nobody appears at all concerned nigh the vulnerability of funding bases). I pretty good floored Michael Oliver (the real experienced IR guy at Lloyds TSB) when I told him this when I took him out to dinner.

[3] The US tends to take hold a regulatory bound on leverage at 20 times. Any farther in addition to the informal dominion is that you lot tin strength out facial expression an intrusive catch from the regulator. [Some comments deleted here.]

[4] [Regulatory footnote removed – partly because it is incorrect – in addition to I am embarrased.]

[5] On the develop between Leeds and Leicester I chatted to a adult woman inwards her fifties nigh the banks. She had a mortgage on SVR (an one-time high margin mortgage) amongst Lloyds TSB. I asked her why she did non refinance it in addition to she told me a story nigh weakened credit. Her hubby no longer worked in addition to her income paid the mortgage in addition to supported the family. She had plenty of equity inwards the solid but she (erroneously) sentiment that she could non refinance. Refinance would take hold saved her GBP500 per year. It was an slowly determination had she been informed. Lloyds is hardly going to inform her. But in that location is a lesson hither – the dorsum volume are going to take hold higher delinquency than the front end volume but without necessarily worse credit. It self-selects this way inwards part. The comparing that Northern Rock had on their delinquency charge per unit of measurement was at best grossly misleading. (There is a possibility that they believed it though which would propose incompetence. In this illustration they misled so transparently they mightiness good exactly take hold been dumb.)