Needed: Big book with the words “DON’T PANIC” printed in friendly type on the cover

UK readers “of a certain age” will no doubt remember the book of which I’m talking, but if ever there were a need for the cover, it is now.

The BBC’s Robert Peston has provided a summary of a speech by Mervyn King, the Governor of the Bank of England.

As Mr. Peston says:

Mervyn King said that central banks could not fix the fundamental problems in money markets

A quick recap of what happened:

• For several years, US banks have been lending mortgages in a fairly cavalier manner (translation: in a way that would certainly be illegal under UK rules)
• They did this because they could “sell on” the mortgage debt, and make a profit not only by selling it on, but by providing on-going “processing services”
• This happened to a much, much smaller extent in the UK, where this type of transaction was dominated by Northern Rock
• Towards the end of last year, the number of people with deep pockets wiling to buy this mortgage debt got small. (The problem was ACTUALLY that a small number of huge banks got worried about their own cash reserves, and decided to stop spending for a month or two.)
• Because of this, some of the banks that had been assuming they could sell on the debt suddenly couldn’t. One of these (and the biggest in the UK) was Northern Rock, which went to the Bank of England asking to borrow a lot of money.
• Word of this got out, there was confusion about what was happening, and queues formed in the streets of people wishing to withdraw their savings from NR (despite the fact that, in most cases, these were covered by the UK’s Financial Services Compensation Scheme anyway.)

Despite Mr. King’s words of warning (and let us not forget that he tries to use speeches to STOP problems happening), I’m not worried for UK property investors.
In fact, so far in January, some of the US “backers” have gone through their accounts, realised that their cash position wasn’t as bad as they’d feared, and started buying again. (Their concern was never that they’d run out of cash, merely that they’d let their cash levels get lower than the levels required by a complex formula enforced by the US goverment.)
However, it’s clear that some lenders in the are still running scared.Overall, though, things are actually looking UP for property investors (in a bizarre kind of way.)

• UK Interest rates went down in December.
• Most analysts believe they’ll go down again next month… and in the middle of the year… and towards the end of the year, so finish about .75% lower than they are today.
• One of the scarey statistics – the so-called “BaseRate to LIBOR spread” (see my report at the end of November) has actually got rather better in the last six weeks.

At the moment, it’s possible that one of three things will happen:

1. Interest rates will come down OR
2. House prices will come down OR
3. Both

Now, why would those be bad for investors expecting to buy rather than sell over the next year?

And, may I remind you, in the last YourPropertyExpert.com survey (which was, to be fair, in August last year, just before the NR stuff), a staggering 83.6% of investors said they expected to buy in the next 12 months, 14.3% said they’d hold, and only 2.1% said they’d sell.

Of course, if your whole strategy has been to “buy gifted deposit offplan flats in the hope that the market goes up, and don’t worry that there’s a shortfall between the rent and the mortgage”, then maybe the words “DON’T PANIC” aren’t appropriate!

A staggering amount of money for Northern Rock.

Dear Mr. Chancellor,

The Northern Rock employs 6,500 people, most of them in marginal constituencies.

You have just promised £25,000,000,000 of public money to keep them employed, as a loan that you only get back if the business ends up doing well.

That works out at almost FOUR MILLION POUND PER JOB SAVED.

If the business tanks, you will end up with the assets of a failing company – mostly some nice office blocks in marginals, where maybe you could create some public sector jobs?

I also live in a marginal constituency.  Our (labour) MP got back with a majority of 19… not 19,000, just 19 (on the third recount.)

My company employs two people.

Would it be possible to arrange for a cheap loan on the same basis. Clearly we wouldn’t require the full £3.8million per head – we’d be happy with just £2.5 million each.

And we promise to pay ourselves no more than the Directors of the Northern Rock.

Obviously, if the business does well, we’ll repay you.

If the business tanks, then for only £5,000,000 of taxpayer’s pounds, you have have control of all the revenues of my book, and my laptop (the two core business assets).

Is no-one else shocked at what’s happened here? The SAVERS money was already protected – the NR had, for years, been paying a levy into the Financial Services Compensation Scheme to guarantee that.

Northern Rock Nationalisation? My off-the-wall solution :-)

Of all the reports about Northern Rock over the last six months, the one that has consistently impressed me most is Robert Peston, of the BBC.

In the latest twist, Robert reports that SRM, a Hedge Fund who currently own about 10% of Northern Rock have written to the Government, making it clear that if the Government try to Nationalise NR at less than a “fair price”, they will sue for damages.

The story then goes on to report how SRM have arrived at a “fair price”, and how difficult it is to value failing businesses.

I have a solution. I’ve no idea whether it would hold water legally, but it has a certain “business logic” and “natural justice to it.”

I wonder whether it could apply to all “companies on the verge of nationalisation”, not just NR…

Run an auction with a twist

• Buyers would have to demonstrate (before entering the auction) that they had the funds in place
• The government would have the RIGHT, but not the OBLIGATION (ie an option), for 24 hours after the auction closed, to buy, at a 10% premium over the “hammer price”
• Of this 10%, half (5% of the highest bid) would be an uplift to the price the sellers of the business received
• The other half (5% of the highest bid) would go to the highest bidder

Why have I suggested this?

• The purpose of the first 5% is to demonstrate, clearly, that the government is paying “fair price”.

• The purpose of the second 5% is to make sure that potential bidders are encouraged to bid up to their highest price – because for just making the offer, and putting down no cash, they MIGHT end up with a 5% profit straight away.

• The purpose of making it an OPTION is to  make sure that no-one over-bids in the hope of that 5% profit – there would be a good chance that the Government would leave them swinging with their over-priced asset And, of course, to make sure that the Government only bought if they REALLY felt it was in the national interest.

Would bidders play? Asia is awash with rich financial institutions at the moment!

And he’s off (Northern Rock Chief Exec goes…)

Adam Applegarth, Chief Exec of Northern Rock, has left today.

The new Chief Exec is Andy Kuipers, who had left a few months ago, but has just been reappointed as a Director!

Virgin seems to be the only game in town left for rescuing the crippled bank, since talks with Olivant (the other bidder) seem to have fallen through.

The new chairman, Bryan Sanderson (who took over in October following the resignation of Matt Ridley), has made the normal positive noises about how Andy Kuipers is the right person for the job.

Northern Rock are being coy about the payoff, and have said the departing Mr Applegarth will be paid “substantially less than the amount which he would otherwise be due.” I suspect that the staff and shareholders who have been rioting in the streets had he been allowed to run the bank into the group and leave with a massive cash bonus (and rightly so – personally, I support big bonuses for people who do well, particularly Entrepreneurs , but have a REAL problem with people who expect big bonuses or payoffs for letting companies fail.)

You’ve got to wonder how long either Mr Sanderson or Mr Kuipers will last when the new owners come in? That, I suspect, is a question that only Mr. Branson can answer!

UK Mortgage Arrangement fees have gone up 87% in the last two years

According to a report by Moneyfacts, over the last two years, the average mortgage arrangement fee was:

•  £441 in November 2005
• £827 now

That’s an increase of over 87%, which is getting close to having doubled.

The trend behind this has been of lenders wanting to quote low headline rates, but make up their profits by charging such fees. About the worst culprit was Northern Rock,  who have been charging such fees as 3.5% on some mortgages.

In September 2006, I wrote an article on the impact of fees, which was beginning to grow then. You can

• Read the article here, or
• Listen to it here

What I said at the time is still true. Iwrote:

The way that I decided to treat the fees was to treat them as short-term loans, that had to be paid off during the course of the mortgage.

The difference, of course, is that those fees have got much, much bigger in the interim.

The conclusion I came to last year is something I also still stand by:

You can probably guess the punchline – I STRONGLY recommend that you go and see an independant financial advisor to present you different mortgage options…

… but I also recommend that you sit down with him/her and ask them how they are treating fees when comparing different products.

What is Mortgage Securitisation anyway, and does it matter? It did to Northern Rock

One of the industry buzzwords being thrown around at the moment is “mortgage securitisation”. This is, it would appear, being blamed for everything from the collapse of Northern Rock to the decline of the NHS.

So, what is Mortgage Securitisation anyway?

Time for another history lesson.

Once upon a time, there were things called Building Societies. Building societies took in money from those who had it (called depositors) and loaned money to those who 1: needed it and 2: could convince the building society that they’d be able to pay it back (called borrowers.)

They would pay interest (at a low rate) to depositors, and charge interest (at a higher rate) to borrowers. The difference was used for three things:

• To pay the running costs of the building society (rent, heating, wages and salaries)
• To take into account the fact that some people wouldn’t pay the money back
• To pay out even more to the depositors, because it was they who owned the building society

There were other places from which it was possible to borrow money, including family, banks, and mob bosses.

The Building Societies, however, had some huge advantages over these:

• They had a lot more money than most families. While you might borrow a few quid from your mum to nip down the shops, most mothers didn’t have enough cash to lend each of their children enough to buy a house. The building societies did have enough money to do this, and hence far more people were, through borrowing, able to buy their own homes rather than rent.
• They had rather less aggressive collection policies than mob bosses. At the worst, they’d take your furniture and your house back, and 99 times out of 100, they’d bother to ask permission from the courts to do so.
• They charged lower interest rates for mortgages than banks did.

Then, about 10 years ago, this all changed. Most of largest building societies, and many of the smaller ones, decided that they’d be better off as banks. As banks, they’d have shareholders, and a bunch of owners who were different from the depositors. They managed to raise a lot of money by selling shares (and “gave away” some shares to the depositors as a sweetener.)

Once they were banks, there were more things they could choose to do (the laws are tighter in some respects for building societies), and they started getting “creative”.

The first thing they could do was borrow money (from people who weren’t depositors) in order to issue more loans. So, a bank wants to lend you £150,000 for your new Buy To Let, they don’t need to worry about getting 100 new customers, each with £1,500 on deposit, in order to cover that.

What some of them started doing was lending out at a Buy To Let rate, say, 6.5%, and assume that they’d be able to borrow the money on the open markets at a lower rate, say, 5.5%… and that the 1% difference would be enough to cover their costs and make a profit. There’s a rate called LIBOR, which is broadly the rate at which banks will lend money to each other.

This approach worked fine with customers who wanted floating rate mortgages – indeed, lenders tried to get customers to accept mortgages tied to LIBOR, so if the rate THEY had to pay went up, customers would pay them more. It wasn’t perfect, because LIBOR changes all the time, but mortgage customers ended up having their interest calculated monthly, so if the rate went up at the start of the month, the bank might have to carry the extra cost until the end of the month. (Of course, if the rate went down, the bank got the benefit straight away, but customers didn’t see the reduction.)

There was a problem with this, though – many customers wanted fixed-rate mortgages… so the banks got more creative. Some took the risk, and hoped that they could forecast the changes in interest rates well enough over a medium-term period (2-3 years) that they could peg their fixed rates at a level that would make them money.

Others decided to “hedge” that risk, basically by buying what was effectively an insurance policy. This insurance policy (called a swaption) was a deal in which they would pay a small amount, and if interest rates moved heavily in a certain period, they’d get a bigger amount back.

However, even this still left one big risk – what if customers didn’t pay their mortgages. Now, up to a certain point, the cost of this is already build in – you and I pay slightly higher rates, effectively to cover the bank against the possibility that our neighbours won’t pay up. (And, of course, the bank has the aforementioned right to ask the courts to take our houses off us if we don’t pay up.)

What the banks then worked out was that the skills of “selling people mortgages”, “processing mortgages” and “taking the risk that some people won’t pay” were fundamentally quite different.

Some decided to outsource the sales process, and offered commissions to “independent financial advisers” would would sell their products. Others kept sales in-house. Many did both.

Some decided to outsource their processing departments, either to India, or to “packaging companies” who’d do all the paperwork handling (many of whom also ended up in India.)

Some decided to outsource the “taking the risk”, and this is what securitisation does:

Say a lender has 1,000 mortgages owed to it. Each of these mortgages is for (on average) £150,000. Some are less, some are more – but the bottom line is that overall, the customers owe the mortgage company £150 million quid.

What the mortgage company would then typically do was register a NEW company. This new company would be sold to external investors… and would BUY the mortgages from the original lender. Typically, that meant that the lender would carry on doing the administration (and, of course, charging the new company a fee for doing so), but the income each month from the different customers would belong to the NEW company, not the original lender.

How much did the new company pay for these mortgages? Typically a bit more than what was owed.

The original lender got several benefits from doing this:

• They made a small (relatively) profit up-front
• They got an ongoing contract to do the processing
• They got someone else to take on the risk of borrowers not paying
• Oh, and as a more technical matter, because the mortgages weren’t on THEIR books, they needed to keep less cash around to comply with the “capital adequacy” rules for lenders.

The new investors got some benefits too – they got to be mortgage lenders without all the administrative overhead of setting up processing departments, and sales departments, and so on… and historically, most people ended up paying their mortgages, so it was fairly easy to predict how much money they’d make… (And some people, say pension funds who know how much they’re going to have to pay out each year, like PREDICTABILITY in their income very much indeed.)

The new investors also had a “liquid” asset – they could sell their shares in this new company rather more quickly than they could ask for repayment of a mortgage if they needed to get their cash back out.

Why is this called “securitisation” – because “securities” are (in the US) another name for “shares”… and the investors were buying shares in the new companies.

OK, that’s what securitisation is – so, what does it mean for us property investors?

By 2000, about 6% of UK mortgages were “securitised” in this way… and the numbers kept on going up.

However, all is not well… last week, Bradford and Bingley sold off a bunch of mortgages in this way – approximately £4 billion pounds worth – but rather than making “a small profit”, they made a loss of somewhere between £15m and £40m in the process (depending on who you ask, and how you count.) So far this year, B&B have securitised about £9 billion.

Northern Rock, on the other hand, have securitised almost £70 billion of mortgages so far this year.

At the next level down, we have Abbey and HBOS, who have done about £50 billion each… but in the context of MUCH bigger financial groups.

In fourth place, though, there’s a massive drop to GMAC at about £15 billion.

What’s changed is that the mortgage lenders (lke B&B) are finding it much harder to do this – so there’s bound to be a “credit squeeze”.

On the bright side, though, Northern Rock was “the big one” – there isn’t another such mortgage lender about to have the same problems (or rather, about to have problems on anything like the same scale.) Even if Abbey or HBOS had problems, they’d be a smaller drop in their overall accounts… and let’s be honest, if, for example, Clydesdale (who have done about £2bn this year) had problems, that wouldn’t have the same     impact as NR.

Northern Rock – Virgin look to be taking over

It is being reported that, as of 18:51 this evening, the Northern Rock board have recommended, and the Treasury have given their approval for Virgin Money to take over Northern Rock.

Northern Rock are expected to make the announcement officially in the morning.

It is likely that the Treasury will remove the “100% guarantee” to depositors that they have offered – apparantly, they have promised to give three months’ notice to depositors if they do so. This is the guarantee that people with Northern Rock savings accounts would get their money back even if the bank went under.

Once this happens (as is likely, no matter who takes over the bank), this should leave depositors still with some protection from the Financial Services Compensation Scheme, which guarantees:

•  The first £2,000 of money from any depositor
• 90% of the next £33,000 from any depositor

It’s currently estimated that we, the taxpayers, have lent Northern Rock £25,000,000,000 (25 Billion pounds) in “Loans” from the Government. The Virgin scheme is expected to repay £11,000,000,000 of this immediately, and take out the rest of the loans on “normal commercial terms”.

The Government have, apparently, ruled out Nationalising the bank, which means that shareholders – the OWNERS of the bank who have to approve the deal – effectively have a choice between accepting the Branson bid, or letting the Administrators take over – which could potentially leave them far worse off.

Well done to Sir. Richard for stepping in here – I’ve been critical of him in the past for trying to make free publicity out of things like the Concorde sales, but what he’s done here seems to be good business as well as good publicity.

Northern Rock – leaked memo?

I was sent what claims to be a “leaked memo” about Northern Rock. A bit of research now reveals that the memo was a copyright document, so I’ve deleted it. However, I do feel OK in reporting what other websites have said.

The  memo, known as “project wing”, is allegedly written by a bunch of financial institutions, including Citi, and Merryl Lynch (both of whom have ousted their chief execs in the last few months), and relates to a  plan to sell off many of the assets of Northern Rock.

One of the scenarios in the memo was that the core mortgage business might remain strong, and that NR represented a good business going forward, which would continue to grow. To be fair the memo also posed another scenario in which it wouldn’t – so, which is more likely?

Or, to put the question another way, “would  you take out a mortgage with Northern Rock today, or would you ask to find another lender?”

Personally, I’ve had an NR buy to let mortgage in the past, but moved away from them many years ago to another lender who my broker felt was better for my circumstances. Today, if my broker recommended them, I’d have a bunch of questions.

Now, to a certain extent, this is the point. Even if my broker could come up with good answers to those questions, he’d know that recommending NR would involve a lot more time and effort, since I suspect that everyone would have such questions…

Crikey, the more time I spend thinking about the whole NR situation with my “property investor” hat on, the more I think the future is grim for them.

It’s a shame – they seem well run from a customer perspective, the staff in the local branch were friendly, polite and professional on the few times I actually dealt with them, and they had low costs for the volume of business they were doing.

The trouble is, their whole business model seems to have been underpinned by a set of  MASSIVE assumptions about  how they would, in turn, finance those mortgages. They didn’t have anything like enough money from depositors to do so, but assumed that they’d be able to borrow it from other institutions on an ongoing basis. Sadly, with the crash in the US sub-prime market, many of those other institutions got cold feet, and weren’t prepared to make the money available any more.

Oops.

[By the way, I'm planning to do a post about "securitisation" which is  another buzz-word to do with how these mortgages work, in a few day.]

To quote Tom Peters (again):

“… [Warren] Buffett long ago gave us fair warning when he said that all the higher-mathematical models in the world can’t overcome problems with the value in the original transactions..”

That’s not quite what happened here. The original transactions were quite good – but the higher-mathematical models that some of the other parties in the deals had been using backfired, and when the knock-on effects finally hit NR, they were huge.

If you’ve not already done so, now would be a good time to read “Fooled by Randomness”, by Nassim Taleb – he saw it coming, many years ago.

Northern Rock – politicians’ responses

In my earlier post about Northern Rock, I made the comment:

Sadly, the whole thing has degenerated into a political circus.

I’ve had an interesting email response from someone who, for whatever reason, didn’t want to post an open comment on this blog.

The gist of the comment was that I was being a bit harsh on politicians from constituencies where a lot of people stood to lose their jobs, since supporting local people is surely the point of being elected.

Actually, thinking about it over the last few hours, I can respect that viewpoint. Our own local MP spent several years defending her party’s official line on our local hospitals, and saw a huge swing against her, only just holding on to her seat. Since her re-election, her line has changed, and she’s more able to balance what local people want with what the central party view is.

My issue with the political wrangling isn’t that politicians are looking to support local jobs… but that they appear to want to do so at such a ludicrous price to the whole community. If the bulk of Northern Rock jobs are in a small part of the UK, by all means spend the money on growth for the whole community, INCLUDING the 6,500 NR staff who are at risk… don’t spend £4,000,000 per head propping up a failing business.

Another comment that’s been made is that this is a loan, not a payment. I am aware of that, but while the Government are saying that they would be “first in line” to receive any payouts if NR goes under, I’ve also seen differing legal opinions on the subject! Anyone who lends money to a business in serious trouble had better be willing to lose it all.

As an aside, if you have views, especially if you disagree with me, please feel free to post them as comments. I’d rather be shot down in flames and learn something than stick to my own position if you can come up with viewpoints or evidence I’ve not considered!

Northern Rock – the story that wouldn’t die

Back in September, I wrote a series of articles about Northern Rock, the troubled UK bank. It would appear that the shouting is continuing.

Just to re-cap the facts to date:

• Northern Rock stopped being a building society and turned into a bank some years back
• Because of this, it is now owned by Shareholders, who are completely different to the “savers” who have accounts with the bank
• It made a bunch of loans, on the assumption that it would be able to borrow the money back from other banks
• Because of the US Problems,  it wasn’t able to, so the Bank of England stepped in (after some pressure from the Treasury), to provide it with a loan facility of tens of billions of pounds
• The news of this got out, and there was a run on the bank, people queued in the streets to get the cash back out of their accounts (about £10,000,000,000 – that’s Ten Billion has been withdrawn in the last 8 weeks).
• Because of THAT, the shares collapsed

Key point is that SAVERS are protected (up to about £30,000 per saver), but shareholders aren’t.

There have been a few bids to buy the bank outright, and several more to buy out part of the bank. However, because Alastair Darling, the Chancellor has refused to make any on-going promises that the Bank of England loan will be held in place much into the new year, Northern Rock is seen as a very risky proposition.

Here endeth the factual part of the post – now onto the opinionated part

At the time, some financial journalists were tipping the bank as a “hot buy”, certain that the shares would rebound. I was not convinced, and it looks like my caution was right – the shares have continued to go down.

Sadly, the whole thing has degenerated into a political circus. Some MPs, who have large NR offices in their constituencies, are making speeches about how the government  should “save jobs” – though at a loan of £25 billion for a company that has 6,500 jobs at risk, that does work out at almost £4 million per job!

Personally, I would have thought that loaning £4 million on favourable terms to a bunch of small businesses would probably create a lot more employment, and wealth, than propping up a fallen giant. Hell, lend me my £4 million on an “if it fails, that’s OK” basis, and I’ll promise to employ 10 people, not just one! I’ll even guarantee that 3 of those 10 will be former Northern Rock employees – they certainly have some polite helpful staff in my local branch, and I’m sure I could find something for them to do if the government were paying.

There’s an interesting followup to the idea of “saving jobs”, though, and whether it works. The figures below are from Tom Peters, and represent the period from 1980 to 1998.

During this period, the European Union had a policy of “protecting jobs”, wheras the US had a policy of “making it easy for businesses to get rid of people”. (The logic being that, if it was going to be easy to get rid of someone, a small business was more likely to take a punt on hiring them in the first place… and that would overall create more employment.)

In that period, the EU gained 4,000,000 jobs… (to be fair, most of these were in the public sector, but still 4 million extra people working is a good thing, surely?)

Over the same period, American companies laid off 44,000,000 people – 44 million people out of work…

… but created a new 73,000,000 jobs over the same period (at other companies, obviously.)

So, over the same period, by having a policy of “make it easy to lose jobs”, the US economy managed to add a net total of 29,000,000 new employees to the workforce. (29 = 73-44)… over 7 times as many extra people working, in a similar sized economy, as a result of a “don’t bother to save jobs – instead concentrate on ‘flexibility’ in the labour pool” policy.

Makes you think, doesn’t it?

(Oh, and for what it’s worth, I’m in favour of using public money to protect Northern Rock savers AND Northern Rock staff, by making sure that they get decent redundancy payouts… but NOT in favour of supporting Northern Rock Shareholders at the public cost, or in favour of putting up £4million per job to keep 6,500 employed.)