Re: Northern Rock - naive question

tim (not at home) wrote:
"Nick" <Nick.Spam@xxxxxxxxxxx> wrote in message news:62acvdF21v9c8U1@xxxxxxxxxxxxxxxxxxxxx
tim (not at home) wrote:
"M Holmes" <fofp@xxxxxxxxxxxxxxxxx> wrote in message news:fpmpr3$4nl$1@xxxxxxxxxxxxxxxxxxxx
Steve <me@xxxxxxxxxxxxxxxxxxxxx> wrote:

It's astonishing that after listening to HOURS of news reports on this from
the BBC etc., no one seems to know what went wrong.
You could read my article, which explains in plain language how the
mortgage markets worked and how they failed. What happened at NR was a
variant on failure to resell mortgage-backs into the securitisation
market. Once they couldn't raise new cash, they couldn't make new
mortgages,
No, it was worse that that. They had no money to support loans that they had already written

tim


Banks usually don't.

Bank's don't usually what? Have money to support the loans that they have written?

I think you'll find that the normal business model is that they do.


No they borrow and lend. Normally banks like this borrow from small savers. But it isn't their money it is still just a loan.

The problem was its business model broke down.

Essentially it was lending a large amount at rate X% and borrowing the this large amount at rate Y%. As long as X% was sufficiently > Y% all was ok.

However its short term borrowing rate Y% rose relative to the mortgage rate X% and the equation broke down.

The break down in correlation between Y% and X% should have been modelled in their risk management systems, both as credit risk and basis risk.

What risk management system?


Indeed!

NR's lending policy had 90% of their loans supported by short term funds that they renewed, IIRC every two years. The terms that they borrowed on were not linked to the terms of the loans that that gave (which *would* be normal banking practice).

I'm not sure what you mean here. There are normally differences between the borrow and lend mechanisms/rate. They maybe different terms, fixed/float based on different instruments, libor, gilts, bonds, swaps even different currencies. There is normally some kind of risk. You may try to hedge it but this is normally not perfect.


As soon as they found that they could not renew those loans on acceptable terms they were f****d. They had nowhere to go. They couldn't increase the rate charged to borrowers because the terms of these loans didn't allow this, and they couldn't ride out the short term loss on each unfunded loan because too big a percentage of their book were these potentially loss making loans and they had insufficient profitable ones to cover that loss.


Yebbut they should have been able to ride out a few months more than they did. AIUI the collapse was triggered by a collapse in confidence as much as anything else. So not only were they facing higher funding costs due to the credit crunch they faced higher funding costs due to perceived credit/default risk. This of course was a vicious circle.

In normal circumstance one would have expected them to have been able to offload their mortgages to another bank but I guess that idea had just gone out of fashion with a vengeance. So I guess that comes under liquidity risk.

"My god how could we have known, it was a twenty sigma event!!". Tossers ;o)
.

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