Northern Rock

To begin, Northern Rock is not bust, or going bust, and The Guardian's comment this morning 'Crisis of confidence could engulf banking sector' is, in my opinion, the sort of cheap sensationalist rubbish that this self-righteous newspaper often criticises in the tabloids.

Northern Rock was a building society, and I suppose most people, including its customers, think of it in that way. People keep their savings in it and it lends these out to people who want to buy homes. However in the late '90s Northern Rock decided to become a Mortgage Bank - the difference being that it would get its money from all over the place, in whatever way was cheapest and most suitable. At the time financial instruments, swaps and derivatives and so on, were becoming more and more prevalent and this seemed more attractive. Nowadays only a quarter of its mortgage lending is financed by customer deposits.

And even from the security point of view this was not such a bad idea. You can withdraw your savings from a building society any time you like, but it is committed to someone else's mortgage it has lent your savings to for the full 25 year term. This is the traditional banker's problem of borrowing short and lending long and for example some longer term funding in NR's balance sheet might well make it better.

Now NR didn't traditionally have the most prestigious client book but it doesn't appear to have been dabbling in 'sub-prime' in America or even here. What has happened is that it has run into a hiccough over its usual everyday funding and the credit squeeze caused by the sub-prime business has led to its having to go to the Bank of England as lender of last resort.

Note that the Bank of England doesn't find NR's management guilt-free and so it has charged its penal rate. NR has been stretching the limits a bit with buy-to-let mortgages and overly high loan to value ratios. Again applause from this blog to Mervyn King the Governor for not just underwriting incompetence by bailing everyone out cheaply but fulfilling its function of keeping the credit markets alive.

A part of the problem - and where the banks are guilty - is that they don't know how to account for some of these instruments - or to put it another way they don't know what level of risk they are running. If at the end of this affair there is an inquest, that is where it needs to be directed.