Storm, The (3 page)

Funds were to be raised not from depositors but from mortgage-backed securities. There was an appetite in financial markets
for packages of mortgages sold on by banks to other institutions through wholesale markets in the City of London. Banks have
long augmented their resources by market borrowing (one reason why they have been able to expand faster than the more conservative,
mutual building societies), and in the last decade there has been a rapid growth in this new, more sophisticated form of borrowing,
known as ‘securitization’. But Northern Rock took borrowing to extremes; it raised 75 per cent of its mortgage-lending funds
from wholesale markets, whereas a more conservative bank such as Lloyds TSB raised only 25 per cent, with the rest coming
from deposits. Northern Rock saw securitization as a way of rapidly expanding its market share. Then, to attract new business,
Northern Rock pushed out the boundaries of what the industry regarded as prudent lending. The traditional mortgage loan, at
most 90–95 per cent of the value of a property and up to three times the borrower’s income, was already looking rather old-fashioned
in the competitive but booming mortgage market around the turn of the century. Northern Rock was willing to go further than
its competitors. There were 125 per cent ‘Together’ mortgages: that is, loans of 25 per cent more than the value of a house
(in the form of a 95 per cent mortgage plus a 30 per cent top-up loan). In a world of ever increasing house prices, borrowers
were assured that their property would soon be worth more than their debt. Loans were advanced on the basis of double the
traditional three times income. The mortgages were sold with evangelical zeal, as part of a process of helping poor, working-class
families to enjoy the freedom and inevitable capital gains of home ownership. Other banks followed suit in what was a very
competitive market – precisely as the Conservative demutualizers had hoped.

The strategy worked, for a while. Share prices soared. Mr Applegarth acquired fast cars and a castle from his share of the
profits. According to the
News of the World
, a mistress was rewarded with five mortgages and a property empire. In the marketplace, Northern Rock doubled its share of
mortgage lending over three years; it held 20 per cent of the UK market (net of repayments) in the first half of 2007, giving
it the largest share of new mortgages. It looked too good to be true – and it was. There was increasing critical comment in
the financial press. Shrewd observers noticed that Mr Applegarth had quietly disposed of a large chunk of his personal shareholding.
Shareholders picked up on the worrying reports, and the share price slid from a peak of £12 in February 2007 to around £8
in June after a profit warning,
and then to £2 in the September ‘run’. One crucially important body did not respond to these concerns: the financial regulator,
the FSA, which to the end remained publicly supportive of Northern Rock’s business model and did little to avert the coming
disaster. Indeed, in July 2007 it even authorized a special dividend from the bank’s capital.

In September the model collapsed, in the wake of the decline of the sub-prime lending market in the USA. Northern Rock was
the closest UK imitator of the US sub-prime lenders whose ‘ninja’ loans – to those with no income, no job and no assets –
were the source of rumours of defaults. Since so much sub-prime lending had been securitized, there was a wider collapse of
confidence in mortgage-backed assets, which, it emerged, were often ‘contaminated’ by bad debts which were difficult to trace.
The market dried up and Northern Rock was no longer able to raise funds to support its operations.

The process by which the Rock was then rescued and, six months later, nationalized, is a tangled and complex story. There
were, however, amid the detail, two important issues of principle. The first was the need to strike the right balance between
the perceived risk of creating a damaging shock to the whole banking system, if one bank were allowed to go bust, and the
danger of moral hazard, if foolish and dangerous behaviour were to be rewarded by a bail-out. I shall pursue the wider ramifications
of this issue in the next chapter. Suffice it to say that, having initially emphasized the latter concern, moral hazard, the
Governor of the Bank of England was then prevailed upon to undertake a rescue.

The second issue was how to strike the right balance between public-sector and private-sector risk and reward as a result
of the rescue operation. After protracted and expensive delays in order to try to secure a ‘private-sector solution’ – which,
in the eyes of critics, including the author, would have ‘nationalized risk and privatized profit’ – the government nationalized
the company, effectively expropriating the shareholders.

Although it was only a relatively small regional bank, Northern
Rock forms a central part of my story because it was the small hinge on which the British economy swung. It opened the door
to the credit crunch and influenced the wider international financial markets. Its extreme mortgage-lending practices marked
the outer limit of the home-lending boom, which is now bursting. And, towards the end of 2009, the government was seeking
to split Northern Rock into a ‘good’ bank and ‘bad’ bank as a prototype for the return of banks to the private sector.

To describe the last decade of UK house price inflation as a ‘bubble’ does not do justice to it. Even in a notoriously volatile
market there are few precedents in recorded British history, or in that of any other major country, for the scale of the inflation.
There were booms in the late 1940s in the immediate aftermath of the Second World War (followed by two decades of depressed
prices in the economic boom years when Britain had Never Had It So Good). There was a short, sharp spike in prices in 1971–3,
followed by another slump until the mid-1980s, and then the boom of the late 1980s and early 1990s, which led to the painfully
remembered era of home repossession and ‘negative equity’. Measured in relation to average after-tax income, housing had proved
– contrary to popular myth – a disappointing store of value. Looking at underlying trends, and ignoring boom and bust cycles
over the post-war period, shares have beaten property – and so has working for a living. But from the nadir of 1995 to the
zenith of 2007 house prices doubled from four and a half times earnings to more than nine times earnings. They more than doubled,
increasing by 130 per cent in real terms (that is, relative to inflation). The increase was more extreme than in the USA or
in any other major Western economy. It was more like a large balloon than a bubble, and as vulnerable to being burst.

Why did the balloon grow so big? Ms Kate Barker reported to the government that the explosion of prices was explained by a
mixture of demographics and parochial NIMBYs using the
planning system to obstruct new development. The only solution was to build more homes. A target of 223,000 new homes a year
was set for the period 2001–16, and councils were instructed to find room for them, whether or not they liked the idea of
concreting over back gardens and diminishing amounts of green space. Yet there was something not quite right about this explanation.
The UK population has increased fairly steadily, from 50 million in the 1951 census to 60 million today, under much the same
planning regime and without, until recently, triggering any sustained shift in the trend growth in house prices. One new factor
since the mid-1990s has been net immigration – but a significant part of this (from eastern Europe) is related to the economic
cycle and is temporary and reversible.

The panic about the housing ‘shortage’ had started earlier in the decade, when there was a fall in the annual construction
rate from around 200,000 new homes per annum down to 142,000 in 2001–2. This was at a time when the government was predicting
an annual increase in households of 223,000 in England and Wales. Ergo, prices must inevitably rise. But as the market saw
unprecedented inflation in response to the ‘shortage’, the reality on the ground was different. Production – which had in
any event fallen mainly because of a drop in public-sector, not owner-occupied, housing – recovered to 173,000 in 2006–7.
And between 2001 and 2006, the number of households increased by only 80,000 a year, according to the Office for National
Statistics. The more expensive houses became, the more children remained with mum and dad, the less family rows led to couples
breaking up, and the more grannies were accommodated at home rather than separately in a big old house or a sheltered flat.
There was something not quite right with the popular explanation that soaring prices were caused by too many households chasing
too few houses.

There are other factors that explained the bubble rather better. Easy credit was the key. Competition among mortgage lenders
produced a bewildering variety of mortgage products – 15,600
in July 2007. They were often aggressively marketed, on terms – in relation to income and property value – that enabled more
and more people to enter the market. Northern Rock was not the only bank willing to lend 100 per cent or more of the value
of a property and five or six times the borrower’s income. The research firm Data Monitor suggests that 7 per cent of recent
mortgages were made to people with a poor credit history, and another 5–6 per cent have been ‘self-certified’, requiring no
proof of income.

As prices rose, the sense that property is a good investment – even an alternative to a pension – also grew. The growth of
the buy-to-let market and of the market in second homes was in part due to speculation that prices would continue to rise,
generating nominal wealth and the potential for capital gains. Ten per cent of mortgages are currently held by buy-to-let
landlords, as against 1 per cent a decade ago. Another former mutual, Bradford & Bingley, specialized in this area of business.
There are also an estimated 276,000 second homes, many of them unoccupied for much of the year (with another 200,000 second
homes overseas), partly acquired for investment purposes. An academic study by David Miles explained 62 per cent of the doubling
of prices over the course of a decade as being due to the expectation of future price rises, with rising population accounting
for only 9 per cent of the price rise (increases in incomes and low real interest rates explain the rest). An IMF study of
changes in house prices between 1997 and 2007 concluded that in the UK (as also in Ireland and the Netherlands) around 30
per cent of the increase in prices could not be explained by ‘fundamentals’, such as population, rising income and lower interest
rates – compared with a figure of around 20 per cent for France, Australia and Spain, and only 10 per cent for the USA. Any
market that is inflated by expectations of future price rises, supported by the easy availability of credit, has the character
of a bubble. Bubbles burst. This one has done, with spectacular and worrying consequences.

What made the British housing price bubble so dangerous in economic terms was that it was so highly leveraged (that is, supported
by debt). The thousands of first-time buyers who acquired what came to be known as ‘suicide mortgages’ of 125 per cent of
the property value were merely the vanguard of an army marching to the rhythm of ever increasing house prices. They borrowed
to the limits of their capacity, or beyond, in order to get a foothold on the housing ladder. Mainly because of mortgages,
but partly also because of personal borrowing, average household debt has risen to 160 per cent of income, double the 1997
level – the highest of any developed country, and the highest in British economic history.

It might reasonably be asked why these developments were allowed to continue unchecked, not least by the guardians of financial
stability in the Bank of England and by the political over-lord of the economy, the Chancellor of the Exchequer. There were
many expressions of anxiety about increasing personal debt, and it was clear that growing numbers of people were being encouraged
– in some cases through aggressive promotion – to take on more debt than they could sensibly manage. In 2002, in the
Daily Express
, I published a warning about rising household debt and proposed a plan to address it. Then, in November 2003, I raised the
issue with Gordon Brown in parliament, in the context of the Budget Report, only to be met with a contemptuous dismissal of
the problem: