The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (31 page)

Part of this process was the emergence of a conveyor belt, a sausage factory of credit risks repackaged via ‘conduits’ in tax havens, an opaque route by which money from conservative banking institutions in places like Germany ended up being lent to financially insecure subprime mortgage borrowers in some of the poorest neighbourhoods of the USA. The AAA ratings, the pattern of rising house prices and the light-touch bank regulations all supercharged the industry before the debacle. These factors were underpinned by the models and assumptions of low correlations in mortgage defaults. All these factors helped cause the disaster.

In Europe there has been a certain amount of
Schadenfreude
at the fate of US hyper-capitalism. Yet Europeans were disproportionately the end-purchasers of these steaming vats of unintelligible garbage. German banks that would never have dreamt of attempting to lend aggressively to actual Germans found themselves inadvertently losing vast sums exporting their capital to bankrupt Americans. And, of course, the City of London performed the role of ‘reg haven’, approving the use of aggressive capital-free credit engineering. I will show in the chapter on Spain (see
here
) that the idea that there was ‘no subprime in Europe’ is a canard. It walked like a duck, it quacked like a duck – it was just a different species of duck. Even in very basic forms of credit engineering, Europe stood out as one of the leaders in the field. In Britain, the subprime duck found its true home on the waters of the River Tyne.

If you went out on any Friday night during the go-go years to the classier pubs and clubs of Newcastle, you’d find them heaving with American investment bankers. Now Newcastle has many charms, but it was not the pleasures of the Bigg Market entertainment quarter nor the games at St James’ Park that had attracted the sharp-suited moneymen to the foggy northern corner of England. They’d come here for Northern Rock.

Seven years on, it was all to end in ignominy and bank runs. Northern Rock had the dubious honour of being discussed for some time at the September 2007 meeting of the mighty US Federal Reserve. This prompted Fed board member Richard Fisher to suggest that Newcastle might be better known as Sandcastle. Alistair Darling, the former UK chancellor who himself had a Northern Rock mortgage, recalls the smug hand-rubbing amongst European finance ministers as they witnessed what they thought was the downfall of Anglo-Saxon capitalism. Plenty has been written about the collapse, the runs and the nationalisation of Northern Rock. But even a sandcastle needs to be built by somebody. This is how you grow and then harvest a 125 per cent mortgage.

For Northern Rock, an ex-building society with a low credit rating, the key question was how they could borrow significant amounts of money in order to lend it on. At its peak, Northern Rock had no more than seventy-five branches, over a quarter of them in the northeast. So it was never going to get enough retail deposits in, even if noughties Britons had wanted to save. So how to fund the desired growth? ‘You can’t do it in the capital markets,’ I was told by one member of the Northern Rock securitisation team, whom I shall call Jon Taylor (he wishes to remain anonymous). ‘You’re Northern Rock, you don’t have a great rating. Until secure technology. Whatever you say, it gave Northern Rock a level playing field.’

Adam Applegarth, Northern Rock’s cricket-playing chief executive, was a marketeer rather than banker. He looked after his staff very well, and he came up with the ‘virtuous circle strategy’ that sought to gobble up market share with cheap innovative mortgage products (see
here
). ‘He just wanted a headline-grabbing punchy product in the market,’ Taylor told me. ‘And naturally, we [in the securitisation department] were the gap. We came up and said “We can do this, this and this.” And of course he was always going to bite our arms off.’ Before 2007, Northern Rock securitisation meant both a source of mortgage funding and off-balance sheet treatment. ‘So by securitising,’ Taylor continued, ‘not only did I get in funds to lend again, but I also freed up capital to hold against that lending. It was the perfect, perfect tool. I needed nothing else to fuel my mortgage business.’

Specifically, this ‘perfect tool’ was called ‘the master trust’. It was designed by First National Bank of Chicago in 1988 for use in credit-card lending, and became the means by which banks could offer a flexible combination of interest rates, credit limits and rewards or cashback from their cards. Citigroup brought it over to Britain. In mortgages it enabled the continuous recycling of that small amount of capital that had been earmarked to support securitised lending. The basics of it was that a multibillion pool of mortgage loans would be transferred to a Jersey-based trust called Granite. Half of Northern Rock’s funding came through Granite, but more than half of its mortgages would cycle through Jersey as they churned off Northern Rock’s balance sheet.

‘Securitisation was a tiny quirky tool early in the 90s,’ Taylor told me. ‘But it really kicked off in 1999 and 2000. And in 2001 they came up with the master trust, which we came to revere.’ That revolutionised securitisation in the UK, he said. The master trust ‘just made it incredibly friendly for investors, so it just took off’.

The mechanics of its operation are extraordinary.

Customers have no clue that they have been transferred. The day a mortgage is securitised, anything to do with that mortgage is no longer the business of Northern Rock. ‘It’s very important,’ Taylor emphasised. ‘Your systems have to be actually rock solid, to make sure that any penny of payment, any pound, any arrears don’t go to Northern Rock. It just had a flag against it on Northern Rock’s internal systems, which means that any cash that comes in, any payment that comes in, because this mortgage was flagged, will get hived off to this bank account, instead of that bank account. So you tracked it and you knew it. The man who looks at the screen who you phone up, he can’t tell if you’re securitised. There were only three or four people who had access to tell if you were securitised or not.’

To the outside world Northern Rock dealt with every customer in exactly the same way. It didn’t influence how a customer was dealt with if they had a query about a new product, or if they were asking for a product switch, or, most importantly, if they found themselves in arrears.

The Granite prospectus meanwhile contained all the details of the individual mortgages it was absorbing: account number, postcode, salary of the borrower, age of the borrower, internal credit score, everything but the name and address – but they were just an internet search away. It was not just new mortgages that were securitised. Most banks in the UK securitised mortgages back to 1994, because of a change in the terms and conditions of mortgage transfer in the UK.

‘That was the beauty of it,’ Taylor told me. ‘I couldn’t go securitising a 1992 mortgage at Northern Rock, because I’d have to write a letter to you, saying “Hey, I’ve sold your mortgage to Granite.” If it’s a 1995 mortgage, I can go and sell it to Granite, and not tell you. Because Granite has sourced back the administration of that mortgage to Northern Rock, so you’re still going to get Northern Rock setting interest rates, Northern Rock headed paper, everything.’

All of this was done with most of the British population completely unaware. Esther Spick’s mortgage (see
here
) is probably in Granite. Alistair Darling’s mortgage certainly was, and might still be. The treatment of arrears was vital, because the whole system depended on making sure that the risk, and the loss, went to Granite. The regulator feared that in order to access cheap funding, Northern Rock would put the best assets into Granite with minimal losses. Mortgages were randomly assigned for the journey to Jersey.

Where Northern Rock differed from other banks using master trusts was in the speed with which it transferred mortgages off its balance sheet. This was the key feature in the Rock’s eventually failing business model. Traditionally a bank would look at assets and liabilities and work out the pricing of their loans. At Northern Rock what mattered was that products such as a three-year fixed mortgage ‘washed its face’ in terms of the cost of funding from Granite. The mortgage portfolio was the funding stream, so the securitisation could stand by itself. So how did they raise the money?

This is where the marketeers came in. Northern Rock dispatched roadshows around Asia, looking to drum up investment. They played on the prestige of Newcastle United, dressing their salespeople in the club’s strip, occasionally gleaning approving shouts of ‘Shearer!’ The Toon strip played less well in the USA, where the black and white stripes resembles a referee’s jersey – but all the same, 65 per cent of the Rock’s funds came from the States. Insurance companies, bond investors, even charities like the Bill Gates Foundation poured money into Adam Applegarth’s Newcastle bank, which in turn focused this money like a laser beam on British property. The Rock was offering returns above Libor (the inter-bank lending rate), at a time when the interest rate on US credit cards was below Libor. Amazingly, in November 2006, on behalf of the mortgage-seekers of Britain, the Northern Rock roadshow reached Africa. Scarce African liquidity, which could have funded local infrastructure, was instead diverted into Northern Rock to fund instant negative-equity mortgages at the very top of the UK housing bubble. For half a century the ‘efficient markets hypothesis’ conquered all in financial thinking. Of the many refutations of the hypothesis since the crisis, this African investment in Northern Rock stands out as one of the most egregious examples.

Northern Rock did not itself slice up all the risk into CDOs. The Rock’s methods were relatively simple. It did, however, pioneer relentless attempts to reduce the capital set aside to underpin their offshored mortgages. Typically, banks would need to set aside 4 per cent capital to cover losses on a mortgage book. Securitisation got that number down to below 2 per cent. Northern Rock always retained some ‘skin in the game’: unlike some subprime US mortgage companies, some degree of risk was always retained on its balance sheet. In the master trust structure this was called the ‘reserve fund’. But the Rock found a way to limit even that.

In 2005 Lehman Brothers’ London office helped design Whinstone, named after the rock that is often found below a layer of granite (the teams thought carefully about these names). Whinstone was the £423 million securitisation of the Granite Reserve Fund. It was a further securitisation of 80 per cent of the Northern Rock’s remaining risk in the Granite securitisation, using those credit default swaps. It was the largest international transaction of this type ever tried, sold to the world in pounds, dollars and euros. The Lehman Brothers’ bankers earned fat fees. Standard & Poor’s upgraded the outlook for Northern Rock’s credit rating on the mere announcement of this deal. Applegarth had been seeking this for many years. Insiders suggest that Whinstone had been designed specifically for the credit rating. After a second Whinstone deal in 2006, S&P upgraded Northern Rock’s rating to A+. In 2007, just forty days before the run on Northern Rock, and the ensuing collapse and bailout, the Whinstone transaction was cited in the Rock’s financial results as the key factor behind ‘an anticipated regulatory capital surplus over the next three to four years’. Whinstone was behind a planned rise in dividends for shareholders and a plan for massive share buybacks. Yet, just three months before, Northern Rock had breached its regulatory capital ratios, and days earlier had completed the forced sale of £833 million of commercial loans to Lehman Brothers to rectify that.

Amazingly, at one point Whinstone was rated higher credit-wise (BBB) than the Granite portfolio it supported (BB). This made absolutely no sense. The risk was all in the reserve fund, also known as the ‘first loss piece’, because if mortgages soured, it would take the first loss. But the end result was that, even in a hyper-competitive market, Northern Rock’s lending took off like a rocket. The conventional Granite securitisation had more than halved the capital that Northern Rock put aside to cover the mortgages, from 4 per cent down to 1.6 per cent. There was a competition on with other mortgage securitisers such as Halifax, Bradford & Bingley, Bank of Scotland, and a host of smaller building societies. Alliance & Leicester had managed to beat the Rock, however, getting the figure down to 1.4 per cent. But then Whinstone regained Northern Rock’s bragging rights in the crazy world of British mortgage securitisation: the capital set aside on these mortgages dropped down to just 1 per cent. With this measure, the team at Northern Rock was again top dog among the feral pack of soon-to-be-bust securitisers.

At its peak in 2007, this sausage factory of mortgage credit on the Tyne was funding a quarter of Britain’s house loans. Perhaps the most incredible thing about this whole machine, though, was the fact that there was no profit in it. Funding through these vehicles channelled a mass of credit through Northern Rock at very cheap rates, sometimes just 0.1 per cent above the London interbank market. But Northern Rock then lent this borrowed money out at a rate only a tiny fraction above that figure – as did many other mortgage lenders. Northern Rock also pioneered computer analysis, and internet rather than branch-based mortgage-writing. Costs were driven down. The end result was the allegedly ‘virtuous circle’ of cheap costs, cheap funding, cheap mortgages, growing market share, cheaper costs, and so on. It was a result of competition in the market. Executives at HBoS, for example, were to admit that from 2005–7 there was very little profit to be made in UK mortgages. In the first instance, new custom was essential, because new custom paid up-front one-off arrangement fees that kept a mortgage just about above water in profit terms for the first few months.

That is why Northern Rock had to grow: it had to write more mortgages in order to continue its business. It wasn’t hubris when in early 2007 Adam Applegarth announced Northern Rock’s ambition to become the third biggest mortgage lender in Britain. It was a matter of survival. The Rock was a Ponziistic monster that had to consume Britain’s mortgage market in order to sustain itself. At the peak of the bubble, Northern Rock’s profit target was the same as its growth target, because they had to grow to be able to book a profit. But the orgy of mortgage giving, the drive to flog even more new mortgage products than one’s competitors, whatever the cost, was to get even crazier.