Background information Northern Rock a building society that was formed on 1 July 1965 as a result of the merger of Northern Counties Permanent Building Society (established in 1850) and Rock Building Society (established in 1865), and a number of small local building societies making an amalgamation of 53 societies became a public limited company in October 1997. Listed on the London Stock Exchange and authorised under the Banking Act 1987, the Northern Rock Foundation, an independent charitable body was also established with objectives to tackle disadvantage and to improve quality of life in the North East and Cumbria. In 2007, when due to sub prime loans from the USA caused credit markets to shrink, Northern Rock became unable to meet the repay of the loans she had taken.
It became apparent that to keep the bank afloat and protect private money saved in the bank, the bank of England in February 2008, Northern Rock was taken into temporary public ownership using some £13 billion of public money guaranteeing The Northern Rock Foundation a minimum income of £15 million per year in 2008, 2009 and 2010.Before facing the crises, Northern Rock had established itself as the top securitisation bank making £6,1 billion in January 2007 and £10,7 billion in the first half of May 2007.
She was the fifth biggest British bank and made a pre-tax profit of £627 million in 20061. Northern Rock strategies from 1997Northern Rock main strategy was borrowing cheap funds when available on the whole sale market and lending to her customers world wide at more attractive rates than her competitors. Cheap market funds are the most risky loans since they are not secured and lack any legal backing such as government backing.
When credit markets get frozen, this means there will no more funds available on the market and the bank will be unable to generate the required money for repayments. Therefore, Northern rock should now concentrate on funding her loans from retail deposits since they are secured and most often based on savings and deposits from clients. In such a way, the bank knows that they are sufficient funds before making any loans. Securitisation by all means is a good idea since it presents a better way of risk management since the risk of funding is diversified.
But pooling the loans from people to put everything on give to lenders, the process works well if there is enough money circulating on the market. But when the credit dries off, it becomes difficult to raise the get back the money given out to investors especially as they too may have invested the money in other market assets. In this case therefore, it will be of great importance if not all loans are sold in form of securitised loans. Management had failed to take note of all market indicators such as the fall in share price and company profit which was cut from 17% to 15%.
In such instances management should have understood that there should be something going on with the world economic system and should tighten credit. But instead management went ahead to issue more loans at lower rates than what it will pay to finance. Another factor that was ignored by the bank was the cut in interest rate by the Bank of England.
When interest rates are cut, it instead discourages savings and increases consumption and investment. In such instances investors will obviously run to the market to buy more funds for their investment further pushing up the interest rate. Thus giving loans at rates higher than what was on the market was a bad strategy. It will be more prudent for management to take good care of market indicators before making loans.