Bank of England makes a last minute decision to save failing lender

Sources: http://www.ft.com/ (Scramble to quit UK mortgage lender; UK homebuyers face tighter loan rules); http://money.cnn.com/ (Bank of England helps lender)

Thousands of customers of Northern Rock, the UK’s fifth largest mortgage lender, withdrew their savings this week after the Bank of England approved emergency funding to rescue the troubled lender. The emergency funding will provide an open-ended facility to Northern Rock, allowing them to access much needed liquidity by posting mortgages and mortgage-based securities as collateral.

Regulators and politicians attempted to calm nervous mortgage holders and investors. Chief executive of the British Banker’s Association, Angela Knight told reporters for the British Broadcast Company that customers of Northern Rock should rest assured that Northern Rock is a sound financial institution. “This isn’t about solvency, this is about a short-term problem that the Northern Rock has in getting liquidity—that is, getting some cash from the normal interbank lending market.” Britain’s treasury noted that the decision to approve the emergency funding was at the recommendation of the Bank of England’s governor and the chairman of the Financial Services Authority. In an official statement, the treasury noted that “the FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

However, despite their efforts, shares in Northern Rock plunged more than thirty percent. The news resulted in the drop of other UK bank share prices as well, including Alliance & Leicester, HBOS and Barclays. Analysts suggest a multitude of reasons for the lender’s failure, including financial innovations in the capital market that allowed small regional lenders such as Northern Rock to harness substantial financial power and excessive lending to Americans with questionable credit histories.

Most experts believe that the prevailing mood of uncertainty will result in stricter lending criteria for potential homebuyers, putting an end to the housing boom of the last decade. Defaults and repossessions have nearly doubled since 2004, and according to a September survey from Rightmove, asking prices are 2.6% lower than they were in August. Richard Donnell, head of research at Hometrack, a property information group, forecasts that the lack of confidence in the market could result in a sizeable gap between asking price and achievable price in the coming months, particularly in large markets such as London. “Confidence is very important to the housing market, especially in central London,” says Donnell. “It has become so hot, pricing was so far ahead of itself, it was at unsustainable levels.”

Questions for Discussion
1. The approval for emergency funding came only two days after Mervyn King, governor of the Bank of England, insisted that the Bank of England would not intervene to rescue the failing lender. What do you think motivated the Bank’s quick ‘change of heart’?

2. Is this a really a short term liquidity problem for a small regional lender, or is it indicative of a significantly larger issue in the UK lending market?