Rock Bottom

Some joined the queues before dawn. Many waited in line for days. But among the armies of customers to besiege Northern Rock bank branches in recent days, there was a common cause. “I’m doing what everybody else is doing,” one elderly man, waiting to withdraw his money from a branch in northern England, told reporters. That meant “panicking. I’m joining the herd.”

He wasn’t kidding. Almost immediately after Northern Rock announced on Sept. 14 that the Bank of England had agreed to make an unspecified amount of emergency funds available to it, worried depositors began retrieving their savings. Although the Bank’s move aimed to reassure punters, it only served to spook them. Worried that the lender — Britain’s fifth-largest mortgage provider — was in danger of insolvency, savers across the country rushed to clean out their accounts, ignoring assurances from the bank’s CEO and Britain’s Financial Services Authority (FSA) that Northern Rock’s capital reserve was sound.

In a run on the bank that lasted several days, savers took back as much as $6 billion of their money (about 12.5% of the bank’s total savings deposits) and helped sink Northern Rock’s stock by 56%. As worries spread across the sector, other banks’ shares dropped by as much as a third. And every day, the lines outside the branches seemed to grow rather than shrink.

With confidence in the U.K.’s banking system stretched, the government felt it had little choice but to step in with a definitive gesture to stem the panic. In an unprecedented move, the Treasury announced on Sept. 17 that it would guarantee all deposits held with Northern Rock. “I want to put the matter beyond doubt,” announced Alistair Darling, the Chancellor of the Exchequer, putting British taxpayers on the hook for billions of dollars of Northern Rock deposits in the (extremely unlikely) event it did default. Users’ cash squirreled away at the bank, he said, “will be guaranteed safe and secure.”

That gilt-edged pledge helped shares in Northern Rock recover. But the conditions that triggered the crisis — not to mention its fallout — look set to linger.

The troubles at Northern Rock jar with the cachet the bank has enjoyed in recent years. Its low cost base, loyal customers and slick operation helped it outperform every other British banking stock in 2006. The lender — not yet 50 years old — “was a darling of the stock market,” says Howard Wheeldon, senior strategist at BGC Partners in London. “It was perceived as a good growth stock with a good model.” Its approach: a limited branch network meant savings chipped in by its own customers amounted to a smaller chunk of the funds it could lend in the form of mortgages. So the company turned instead to other banks for cash. The result: three-quarters of its funds were borrowed from the wholesale credit markets, versus around half at rival mortgage bank Alliance & Leicester and 25% at Bradford & Bingley. “For years,” says Wheeldon, “they made the wholesale markets work for them.”

Eventually, those markets stopped working so well. The collapse of a U.S. subprime mortgage sector built on lending to home buyers with poor credit histories has given global credit markets the jitters. With that risky debt spliced, repackaged and sold around the world, uncertainty over just who was exposed to the debt — and to what extent — meant that rather than lending around their cash, banks have taken to hoarding it.

That’s left Northern Rock hanging. But while the bank may have been brazen to rely so heavily on the markets, as a solvent lender with a good quality loan book, the hit it has taken from the subprime mess was unexpected. While French, German and Dutch banks have come clean in recent weeks over their direct exposure to low-quality U.S. real estate loans, it was the barren money markets those loans helped create that upset Northern Rock’s model.

The fact that Northern Rock has never really been in serious danger of going bust throughout this crisis scarcely mattered amid the clamor to withdraw funds. “When people hear the words ’emergency’ and ‘bail out,’ then concerns outweigh those statements saying ‘the bank’s solvent,’ ” says Nic Clarke, a banking analyst at Charles Stanley in London. “It doesn’t really matter if the rationale is right or wrong — they’re voting with their feet.”

Part of the panic surely rests with the U.K.’s relatively modest deposit insurance system. Only deposits of up to around $63,000 are protected under the U.K.’s industry-funded Financial Services Compensation Scheme. Britons stashing away more than that have no legal guarantee they will see their savings again if their bank fails. Higher insurance caps — in the U.S., for instance, the Federal Deposit Insurance Corporation guarantees depositors up to $100,000 — would have done much to thin the lines. Keen to avoid the kind of panic triggered among Northern Rock’s savers, the Treasury, the Bank of England and the FSA are now expected to overhaul the insurance system.

A future change in the limits is little consolation for Northern Rock now. Although the bank runs have stopped, it still faces formidable challenges. The credit crunch and dry interbank lending market will make it more difficult for Northern Rock to finance new mortgages at competitive rates. And with its share price still in tatters, it could soon find itself bought out by rivals. (Its stock slumped again on Sept. 19, amid rumors of an imminent takeover bid.) Are other British banks similarly vulnerable? Less so, since they never relied on the credit markets to the degree Northern Rock did. Even so, “we’ll see a slow pull back” in their reliance on other banks for cash, reckons BGC Partners’ Wheeldon. Looking at the consequences of Northern Rock’s over-reliance on a single, unexpectedly risky revenue stream, he says, “they will have learned lessons.”

In the meantime, just as central banks in the U.S. and euro zone have pumped cheap cash into money markets to boost liquidity in recent weeks, the Bank of England announced plans to inject almost $30 billion into the U.K. system after the credit squeeze nudged up the rates banks were charging each other to borrow. The longer those rates remain high, the more mortgage providers will be forced to pass on the costs to homeowners, increasing the chances of a consumer spending slowdown and a weakening economy. That prospect — and the dramatic half percentage point cut to 4.75% by the U.S. Federal Reserve to its key federal funds rate, its first cut in four years — will heap pressure on the Bank of England to reduce U.K. rates, now at 5.75%, before the end of the year. A big enough cut, and people may well start rushing back to lenders’ branch offices: this time, to refinance their mortgages.