Northern Rock: The economic crash's canary in the coal mine

Brian Kavanagh was on his way home, having been out to dinner with his wife, when he got a call at 9.45pm on September 13th, 2007. The banking executive, who had set up UK lender Northern Rock's Irish deposits gathering business eight years' earlier, was told by his boss in Newcastle that the company was applying for emergency funding and that the BBC was about to break the story on the News at Ten.

“I was surprised, because there was no sense of panic at all,” recalls Kavanagh.

After the broadcast customers logged on to Northern Rock’s website by the thousands, causing it to crash and triggering the first British bank run in 150 years. It was the first signal on the street in Ireland that all was not well with the global financial system.

The Newcastle-based upstart’s aggressive growth to become the UK’s fifth-largest mortgage lender was aided by a flagship product which offered loans of as much as 125 per cent of the value of a home. Northern Rock’s top brass briefly entertained entering the Irish mortgage market around 2004.

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“However, I suggested to the guys there was a lot of competition out there and that we’d really have to build a huge administration around it,” recalled Kavanagh. “I asked them, if they were doing so strongly in the UK at the time, which they were, why would they bring on an extra risk?”

By 2007 the Irish operation, based on Dublin’s Harcourt Street, had built up a €2.5 billion deposit book with 33 staff to help fund Northern Rock.

“I came into the office just before 6am the morning after the news and I didn’t see anyone at that stage. But others coming in at about 7am said that people were already starting to queue,” said Kavanagh, adding that the crash of the bank’s website, was the catalyst for queues outside its UK branches and also outside its low-key Irish office, where numbers ran into the hundreds that Friday.

“Customers were visibly upset. They genuinely thought that their life savings were gone,” said Kavanagh. “And while there was a lot of uncertainty among my team about their own jobs, they knew that customers were nervous and tried to allay those concerns as best as possible and to start taking instructions and processing them.”

The UK government stepped in within days to underpin Northern Rock, extending £37 billion (€40.4 billion) in funding and ultimately nationalising the lender the following February.

Ten years after the crisis, most of those borrowings have been repaid, with a remaining debt of £4.6 billion owed by NRAM, a bad bank set up to manage the failed lender’s mostly mortgage loans.

A group of small Northern Rock shareholders, wiped out when the bank was seized, has used the upcoming anniversary to renew a long-running campaign for compensation, claiming that the UK government will ultimately make a £9 billion profit from the exercise.

Contagion

While Irish banks, and the analysts covering them, largely maintained at the time that there was no contagion locally from the Northern Rock shock, it subsequently emerged that deposits in other banks had started to leak.

“I attended an Irish Banking Federation meeting in October or early November of 2007 and apologised for bringing attention to the Irish banking system,” said Kavanagh. “But I remember saying that, while it happened to us, it could have been anyone.”

While Northern Rock would be a canary in the coal mine, the crisis didn’t reach a head for the Irish banks for a further 12 months. Then the government was forced to introduce a snap guarantee of the main lenders as the global financial system teetered on the brink, weeks after the collapse of Wall Street investment bank Lehman Brothers.

The State, which was forced into an international bailout in 2010 to help cope with bank costs resulting from the guarantee, expects to recoup less than half of the gross €64 billion subsequently committed to the financial system.

The €34.7 billion poured into the now-defunct Anglo Irish Bank and Irish Nationwide has gone down a black hole.

The legacy of the crash still lingers. Home prices – although they have surged 58 per cent from their 2013 low – are still 29 per cent off their 2007 peak. The State is left with controlling stakes in AIB and Permanent TSB, while all banks continue to struggle with high levels of non-performing loans (NPLs).

Back in September 2007, bankers, regulators, policymakers and economists were largely whistling past the graveyard.

Economist Patrick Honohan, who had previously been an adviser to Garret FitzGerald when the latter was taoiseach in the 1980s, began to take a closer look at local developments when he joined Trinity College Dublin in 2007 after the second of two long stints with the World Bank.

“I remember being at a conference on housing finance in Oxford in September, two days before Northern Rock collapsed. The place was full of economists who were quite expert on British housing and, while there was some discussion about the prospect of a meltdown, they were breezy about it and were largely saying the situation was very much under control,” said Honohan.

“I remember asking rhetorically at the post-conference reception what if a big bank went down. Such a possibility did not seem to be much on people’s radar then.”

But some were already joining the dots. In early July fears were growing about the US subprime mortgage market. Chuck Prince, then chief executive of US banking giant Citigroup, sought to play down the impact of those jitters on the cheap credit-fuelled global mergers and acquisitions market. However, his comments rattled those already concerned that a financial bubble was forming and about to burst at any stage.

"When the music stops, in terms of liquidity, things will be complicated," Prince told the Financial Times on July 9th that year, "but as long as the music is playing, you've got to get up and dance. We're still dancing".

In the offices of the National Treasury Management Agency (NTMA), executives in charge of managing the State’s funding took a decision by August 2007 to stop placing deposits with banks.

Then on September 7th, 2007, University College Dublin economist Morgan Kelly penned an article in The Irish Times. Under the headline "Banking on very shaky foundations", he warned that Irish lenders' massive exposure to the slowing commercial property market posed "a grave threat to bank solvency".

The previous December, the economics professor, whose career up until then had largely been focused on medieval population theory, predicted house prices would fall by as much as 50 per cent. Indeed, the US housing market had already started to stutter by that stage. The world changed for Northern Rock on August 9th, 2007, when financial markets turned sour as French bank BNP Paribas froze assets in three funds, citing problems in the US subprime sector. An immediate reaction by the European Central Bank to pump almost €95 billion into the banking system – amid a surge in the rate at which banks were prepared to lend overnight to each other – did little to ease nerves.

The problem for Northern Rock was that its model was based on raising funds for its mortgage business by refinancing existing pools of home loans in the financial markets through selling bonds – a process known as securitisation. A pioneer in this field, Northern Rock had sold off half of its mortgages by the end of 2006 in securitisation vehicles. At the time, about three-quarters of its funding came from capital markets, leaving it on the front line when the markets dried up.

During the 2015 Oireachtas banking inquiry, it emerged that the Central Bank began to look in 2007 at what might happen if Ireland had a Northern Rock event, including access to emergency liquidity lines and how an ailing lender might be nationalised.

Phoney war

However, Honohan, who would become the Central Bank’s governor in 2009, said the period between the Northern Rock run and the implosion of the US investment bank Bear Stearns the following March was similar to the eight-month “phoney war” period from the start of the second World War where very little happened.

“There was a widespread view at that time among many of the world’s financial policy experts that the worst was already over,” said Honohan. “I went to a couple of conferences on the crisis in London around that period, particularly one in early March 2008, where speaker after speaker was talking more or less in the past tense about the great disturbance and how lessons had been learned.”

If the Irish response was behind the curve, to an extent it mirrored what was going on internationally, according to Honohan.

“But the authorities could have told the banks not to pay any dividends and gone ahead and introduced bank resolution regulations along the British lines,” he said. “Still, nobody had all the pieces of the jigsaw to see what was ultimately going to unfold.”

Ireland’s banks – which were largely purged of their toxic commercial property loans in 2010 and 2011 by the formation of Nama – continue to grapple with the effects of boom-time mortgages, as home prices quadrupled in the decade to 2007.

It emerged this week that Permanent TSB, the State’s one-time main mortgage lender, has opened a new front to bring down what is the highest ratio of non-performing loans among surviving banks, at 28 per cent of its total portfolio. The bank has written to a couple of hundred buy-to-let borrowers in default, offering to write off any arrears on the sale of the property if they agree to a voluntary sale. The pilot scheme may be widened in time.

The company has also launched a search for investment banks and accountancy firms to advise on potential sales of soured loans. Its €2.68 billion of “untreated” loans – either because the bank can’t find a sustainable solution or the borrowers haven’t engaged – will be at the centre of any disposal programme.

The wider Irish banking system is coming under growing pressure from the European Central Bank to cut non-performing loans. While domestic banks have cut their ratios from an average of 27 per cent of their loan books in 2013 to 14.2 per cent at the end of last year, they remain well above the 5.4 per cent EU average.

Financial regulations have been tightened considerably in the past year and politicians, in Ireland and abroad, insist lessons have been learned. But Kavanagh, who now works in the anti-money laundering sector, says this will be tested when the next cyclical economic downturn occurs.

"You've got a production of The Great Gatsby running [in the Gate Theatre in Dublin] at the moment, reminding us of the roaring 1920s in America before the Great Depression. Do we ever really learn the lessons?

“But at least banks are much more focused on risk and compliance now. That’s a fundamental change.”