Immoral hazard and Northern Rock

What follows is a much expanded version of an OpEd piece of mine, Did Gordon Brown have a choice over Northern Rock? in the Daily Telegraph of Tuesday, 19 February 2008.

Introduction

There’s been a bit of a cock-up on the economic management front. Northern Rock’s nationalisation is the latest Act in a 12-Act tragicomedy that has landed that bank in the company of Railtrack. Let’s recall the main facts. Northern Rock, a medium-sized UK mortgage bank (assets around £110 bn), had been pursuing a very aggressive policy of expanding its market share. In the first six months of 2007, Northern Rock had grabbed 40 percent of the increase in gross UK mortgage lending and 20 percent of the net. A full 75 percent of its funding did not come from deposits but from short-term borrowing in the wholesale markets, mainly through the issuance of asset-backed securities. When the US subprime crisis erupted in August, the UK and international wholesale markets seized up and froze. Unable to roll over its maturing debt, Northern Rock went to the Bank of England for financial support. With the agreement of the FSA and the Treasury, the Bank of England created the Liquidity Support Facility through which it has now lent about £25bn to Northern Rock, secured against Northern Rock’s assets – mostly prime mortgages. The exact terms on which these funds were made available, or the methods for valuing the collateral, have never been disclosed, but are likely to involve a subsidy from the tax payer.

No sooner had the lending facility to Northern Rock be announced, or the depositors started a run on the bank. To halt this the government not only guaranteed all retail deposits but also, quite unnecessarily, the wholesale deposits and most of the unsecured debt, other than subordinated debt and other hybrid capital instruments, the bank’s debt to its own securitisation vehicle, Granite. Covered bonds (a type of collateralised bonds) were also excluded. For this guarantee, Northern Rock pays the government an unknown fee, which once again is likely to involve a government subsidy. The total exposure of the government to Northern Rock is now of the order of £60bn.

I never believed there was much of a chance that a private party or consortium would be able to take over Northern Rock, pay off the tax payer reasonably promptly and make money. Not surprisingly, Olivant threw in the towel before the deadline for bids on February 4, 2008. Branson’s Virgin Group’s bid would have picked the tax payers’ pockets too blatantly.[1]The bid by Northern Rock’s own management was a seriously underfunded no-hoper. Both remaining bids required continued large-scale and probably long-term government financial support.

The consequences of nationalisation

Public debt

Well before the government decided to formally nationalise Northern Rock, the Office of National Statistics had already decided that Northern Rock would be classified as a publicly owned company, as it was clear that the government was taking all important strategic decisions. This added about £90.7 to the reported debt of the government. Unless the assets of Northern Rock are set against these liabilities, the government will exceed the 40 percent of GDP limit it has set itself for its net financial liabilities under the so-called ‘Sustainable Investment Rule’. No doubt it will grant itself a waiver. The government should, in due course, get its money back, however, so there ought not to be any substantive fiscal impact.

Political embarrassment

The nationalisation of Northern Rock is deeply embarrassing to the Chancellor, but even more so to the previous Chancellor and current incumbent of Downing Street 10. It was Gordon Brown who took responsibility for banking supervision and regulation away from the Bank of England when it was given operational responsibility for monetary policy. This resulted in the separation of information about individual troubled banks (which is now with the FSA) from control over the financial resources to assist individual troubled banks (which remains with the Bank of England). The prime minister was also responsible, as Chancellor, for the Tripartite Arrangement between the Treasury the FSA and the Bank of England for managing financial crises – an arrangement that manifestly malfunctioned last August and September.

The nationalisation of failure and the abject surrender to the party-political imperative to ‘save’ jobs, even when these jobs are no longer viable because they are in a sector that has over-expanded and needs to contract to a commercially sustainable size, is so ‘old Labour’ – and pre-Thatcher old Tory for that matter. This ‘when in doubt, bail it out, when all else fails, nationalise’ industrial policy is a blast from a best-forgotten past, even though it was born this time not of conviction but out of government’s indecisiveness, procrastination and the absence of the courage of its New Labour convictions.

While deeply embarrassing, nationalising Northern Rock was obviously politically less embarrassing than the only private sector solution that still remained open: letting Northern Rock sink or swim on its own, by terminating financial support through the Liquidity Support Facility, while maintaining the deposit guarantee (to prevent a run on the bank). This would, with a probability verging on certainty, have resulted in virtually immediate default by the bank and in its being put into administration. The subsequent likely liquidation of Northern Rock and the sale of its assets would have led to immediate significant job losses in the North East, as opposed to the more gradual job losses under nationalisation. In the government’s dictionary, the words ‘bank failure’ carry an even more disastrous connotation than the word ‘nationalisation’.

There is (fortunately) not much of a tradition of public sector banking in the UK. Establishing an arms-length relationship between Northern Rock and its new owner will be difficult. Will the bank be as rigorous in its employment practices (especially as regards dismissals) as it would have been under continued private ownership. Will it pursue non-performing mortgage borrowers with the same diligence shown by private banks. How easy will it be for what will be viewed as ‘Gordon’s and Alistair’s bank’, to initiate repossessions and if necessary to evict delinquent mortgage borrowers from their homes? Will the bank offer aggressively priced deals to savers and borrowers? I hope that the European Commission keeps a keen eye on the institution after March 17, 2008, when the 6 month grace period for state aid expires. The scope for market- and competition-distorting practices is definitely there.

The shareholders

There is likely to be extensive litigation about shareholder compensation, but in the end, the law is likely to follow the economic and commercial logic of the case: without the reality and the anticipation of government financial support, Northern Rock has no shareholder value and has had none since the crisis broke in September 2007. The shareholders should therefore get nothing. At most they should get nothing now and be last in the queue of claimants for the proceeds of the eventual re-privatisation of Northern Rock or the disposal of its assets.

Claims to be bought out at book value (about 430p per share, as opposed to the market price of around 90p per share Northern Rock last traded at before trading was suspended) are fanciful. Book value is of historical interest. It bears no relation to the fair value or opportunity cost of the shares today. In the grey market, Northern Rock shares yesterday (Monday 18 February) traded for 2p or 3p. Even that represents to triumph of hope over sense. Probably from the moment the Liquidity Support Facility for Northern Rock plc was announced on 14/09/2007, and certainly no later than 17/09/2007, when the deposit guarantee was announced, it was clear that Northern Rock would have defaulted on its obligations and gone into administration without government financial support. This makes the shares in the bank worthless without government financial support.

This is hard, especially on small shareholders who may have held their shares since the demutualisation of Northern Rock in October 1997, but as the warning on the investment broker’s brochure says (or ought to say): ‘the value of your investments can go down as well as up’. The two hedge funds that bought up sizeable equity stakes in Northern Rock when it first became clear that the company was in terminal trouble made their bed and have to lie in it. They are set to lose a bundle. Better luck next time.

Employment

Compared to the alternative of letting Northern Rock go into insolvency, nationalisation brings short-term political advantages, short-term job survival for some Northern Rock staff but serious long-term economic costs. Currently, Northern Rock employs more than 6000 staff in the North East. Even under nationalisation, expected job losses at Northern Rock in the North East have been estimated at over 3000.

Eventually (probably within a couple of years at most) the number of jobs lost in the mortgage lending sector will be the same under public ownership for Northern Rock as it would have been had Northern Rock been left to sink or swim on its own. The mortgage lending sector has over-expanded and needs to contract. Under continued public ownership the job losses will come a bit more slowly and will be spread a bit more widely. The transitionally

Moral hazard, here we come: perverse incentives for risk taking in the banking/financial sector

The main damage done by this bail-out – and this nationalisation is indeed a bail-out – of Northern Rock’s creditors, employees and other stake holders (if not, as I fervently hope, of its shareholders) – is to future incentives for prudent lending and funding in the UK banking sector. It is clear now that no bank is small enough and systemically insignificant enough to fail. Northern Rock’s failure would not have constituted a threat to the stability of the UK financial system, as long as the deposit guarantee remained in place. Surely the authorities must by now have figured out a way to ring-fence the deposits of Northern Rock in case of it going into administration, so as to ensure a swift and efficient pay-out of the guaranteed balances? If Northern Rock cannot, for political reasons, be allowed to fail, then all creditors to UK bank have become the beneficiaries of at least a partial free government guarantee.

There are enough distortions that make for excessive risk taking in the financial sector in general and for the banking sector in particular. Limited liability is a wonderful institution, but by limiting shareholders’ exposure to losses, it also encourages excessive risk taking. The separation of ownership and control in modern large banks and other corporations can give CEOs and other managers perverse incentives to take excessive risk. Bonuses cannot be negative, with effects similar to those of limited liability. The ending of debtors’ prisons was a great step forward for humanity, but that reduction in the penalty for default also encourages reckless borrowing. Limited liability combined with leverage makes it possible to take enormous financial risks in the financial sector (vide Leeson and Kerviel). Free labour – labour contracts cannot tie an employee to the job – are the hallmark of a civilised society (the alternatives include slavery and indentured labour), but it also means that bank employees cannot credibly commit themselves to stay with their current employer. Every star banker is structurally footloose – free to leave at any time. Horizons thus become short; myopic and opportunistic behaviour is rational; investing time and effort in long-term relationships is under-rewarded; employees tend to be rewarded for short-term performance only.

Many of these causes of excessive risk taking in the financial sector are the unavoidable price we have to pay for otherwise valuable institutions and arrangements. One would not wish to end limited liability, bring back debtors’ prisons, slavery and indentured labour or ban borrowing. More could, however, be done to design and enforce sensible reward and incentive systems for CEOs, other top managers and star performers in the banking and financial sectors.

Conclusion

It truly is a particularly perverse form of piling Pelion on Ossa to add to the deep-structural, often unavoidable reasons for excessive risk taking in our financial sectors, the further government-made incentives for excessive risk taking in lending, borrowing and other investment and funding activities, inherent in the free option of nationalisation for a bank threatened with default and insolvency.

Future Northern Rocks will be encouraged to fund themselves recklessly and to lend and invest recklessly. Their creditors are after all the beneficiaries of a free government guarantee. If their bets come off, management, super-employees shareholders and creditors benefit. If they fail, the shareholders may still lose (I hope), but taxpayer picks up the tab for the rest.

Is this aggravated moral hazard the legacy the government wants?


[1]Rumours that, if successful, the Branson group would have changed the name of the bank to Northern Virgin (something of an oxymoron) have not been confirmed.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

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