Between a Rock and a load of Granite – how to pay for mortgages

In Northern Rock’s 2006 Accounts they reported how well they were doing. They commented “ The low risk nature of Northern Rock’s balance sheet is reflected in the mix of assets…These assets are well funded through a well diversified range of assets.” They looked forward to further low risk growth, and told their shareholders that the new regulations under Basle II would mean they could reduce the amount of money they needed in their business to support the then level of activity. What a difference a year makes.

Last year they put aside £126 million for possible losses on their lending, most of it for the unsecured loans they had offered people on top of their mortgages. This represented just 0.15% of the amounts they had lent. This year I am sure the new management will want to look at this and step it up considerably. They may also wish to record losses on many other features of the Northern Rock business, as prudence would dictate lower values for some of the assets on the balance sheet, and putting money aside for redundancies and future re-financing costs. There is likely to be a lot of red ink spilled as Auditors and new management try to agree what is fair. The taxpayer will take the hit.

The media and political classes have suddenly alighted on the issue of Granite, the offshore financing company that has issued substantial amounts of paper to its investors, and which holds a lot of Northern Rock’s mortgages. In order to understand what is going on , we need to look at how a mortgage bank can raise money to finance its business.

Northern Rock prided itself on using four principal methods to raise money to lend to people, claiming this showed it was prudent and not too dependent on any one method.

The first is to collect money from savers, through so called retail deposits. If you or I put our few hundred pounds into a bank or building society we are letting them use our money to lend to people on mortgage. Some MPs now seem to think this is the right way to finance a mortgage business, and think it is the prudent way. 22% of Northern’s business was paid for by these deposits at end 2006. Paradoxically, it was this method of finance which led Northern Rock to borrow so much money from the taxpayer, because once the small savers lost confidence in the Bank they wanted their money back, leaving Northern short of funds. It is the ultimate example of borrowing short to lend long – many of the small savers place their money with banks like Northern in deposits where they can get their money out in a day, or with a month’s notice. Mortgage banks lend this money on for much longer time periods, usually safe in the knowledge that their depositors will not all want their money back on the same day, and confident that others will come along to deposit.

The second is to borrow from the money markets – so-called wholesale funds. 24% of Northern’s money came from this source at end 2006. Much of this borrowing is also short term, but banks can usually rely on being able to borrow it over and over again, so again it is usually safe to lend it out for much longer periods. This source of funding dried up in the Credit Crunch of September 2006.

The third is securitisation. 43% of Northern’s money came from this source by end 2006. The bank packaged up groups of mortgages, and sold them to a Granite offshore company. The buyers hold a piece of paper in a Granite company, and receive interest payments based on the mortgages within their company. This financing can be arranged for longer time periods, like the mortgages themselves.

The fourth comes from issuing bonds, where the bondholder lends money to the company for a fixed period. These too can be for longer periods than 1 and 2 above. Northern raised £6.2 billion in bonds, offering mortgages as security for those as well so the bondholders would get their money back if anything happened to Northern Rock itself.

Northern’s critics now tell us this was a risky business model, because it entailed borrowing short and lending long. All banking involves an element of that – that is how banks make their money because they can charge more for the longer term loans they make than they have to pay for the short term money they borrow. They can also, of course, charge more for the loans they make to reflect the greater risks of those loans. Northern’s collapse resulted from the sudden drying up of the money markets, followed by the swift withdrawal of too many retail deposits. Two of its four funding methods went wrong.

The sudden fascination with Granite is probably overdone. Northern took the prudent line on reporting Granite. It kept all the loans and all the borrowings on its own balance sheet. It did so because it manages the mortgages in Granite, and because it has to replace any mortgages that fail to meet the standards required, and because it has to top up the Granite companies with new mortgages if the mortgages are repaid too quickly. Northern also has securitisation arrangements through Dolerite Funding and Whinstone, on a more modest scale than Granite. These are also clearly shown in the last Accounts on the balance sheet.

The argument over Granite revolves around the government saying they are not nationalising the Granite companies and the Opposition pointing out that Granite is part of Northern Rock’s balance sheet with obligations from Northern Rock to Granite that will continue. In addition Northern has an £8.4 billion investment in Granite.

The bigger argument will become how much value can taxpayers put on all of this? The 2007 Accounts are likely to look very different from the 2006. I expect to see some hefty write downs in Northern Rock’s asset base. Valuing their share in Granite is just one part of a much more complex and difficult picture. The valuers also have to take into account the interests of all those who have made money available through securitisation to the Northern Rock business.