Monday, June 9, 2008

My old notes on Northern Rock

In 2005 I travelled to the UK to study the UK banks. I should have shorted the lot of them. But I didn’t. But for the record here are my notes – written on a slow English train – about Northern Rock – and never finished. I have edited it only to remove references to my actual sources.

I put this up not to gloat (but its nice). Rather I am going to do an expose of another UK bank shortly.

I cannot gloat too much - because whilst these notes are amazingly prescient I did not make a fortune on the stock. I predicted rain - but its making an ark that counts!



Northern Rock – leverage mortgages to the max

Northern Rock is a very simple bank. It has only one strategy and it makes no bones about taking this strategy to its absolute limit. They are completely non-forthcoming about where the limit of this strategy might be – but we will see that later.

The strategy of Northern Rock is to grow the mortgage book. Fast. All decline in margin is to be made up by volume growth. They are absolutely explicit about this – the corporate objective is:

  • Grow the asset base by 25 per cent per annum plus or minus 5 per cent
  • Grow earnings by 15 per cent per annum plus or minus 5 per cent.

It is pretty clear that they have even de-emphasized the old building society funding base which is I think might be actually shrinking before “hot money” high rate deposits and foreign deposits[1]. At the conference they told us how they were still concentrating on the deposit base but it had the tone of protesting too much. Besides its clear that rating agencies and bond markets want some deposit based liquidity.

I am also not exaggerating in the slightest about what the corporate strategy actually is. The management must have used these two bullet points five times in my presence (and I was not with them long).

Well it is pretty clear that growing the balance sheet by 25 per cent per annum grows risk by something near 25 per cent per annum (the company will deny this – more on that later). Growing profits by 15 per cent per annum means that capital will wind up growing by 15 per cent per annum (give or take a little).

If you grow risk by 25 per cent and profits and capital by 15 then either

  • You will run out of capital and the regulators or rating agencies or bond markets will not allow you to fund your growth – in which case the growth fizzles out at best, or

  • You will eventually be taking so much risk that the return on capital will not be rational in an ex-ante basis. Some point ex post you will blow up, possibly spectacularly.

If you think I am exaggerating what this strategy is then here are the five year summary numbers from the annual report. Ten year numbers were reported at the conference and they had pretty well the same appearance.

INSERT [sorry I wrote this on the train and had a hard copy of the annual. I never bothered putting the actual table from the soft copy in the report]

Note there is no credit data here. Nowadays credit losses are negligible in UK mortgage banking.

Obviously you should notice the massive expansion of leverage in this book. The asset number to look at is the “total assets under management”. This number includes securitised mortgages where the residual credit risk is at Northern Rock. (The main buyer of this paper are Japanese banks both major and regional.[2]) The total leverage of book has moved from 27 times to 42 times. Obviously this can’t go up for ever but I suspect it can go for quite some more time. (You will see that 43 times leverage is not unusual for a UK bank.)[3]

When I was with the company I tried to explore the limits to the strategy and got nowhere useful. It would be nice to know though because when the company reaches the limit of its leverage it would be a safe short (unable to grow and possibly facing further margin erosion). Until then its probably a better long then a short as there seems no impediment to earnings increasing at at least the teens and the PE is only XXX now.

That said – here goes for my discussion about the limits to Northern Rock’s growth. The company told everyone at the conference that mortgages were safer than conventional loans probably deserving a 33 per cent risk weighting. In Australia and the US the standard is 50 per cent risk weighting for mortgages with no insurance less than 80 per cent loan to value (LTV ratio) so by international standards 33 per cent is aggressive.[4] That said Northern Rock suggested that there mortgages were substantially safer than the average (measured delinquency at about half the market rate) and hence they should have half the risk weighting – call it 17 per cent. They even went as far as to say that the regulator agreed with them. [Some comments have been removed here because they report indirect comments from regulators. I cannot vouch for them on this blog.]

Now if your mortgages require only a 17 per cent risk weighting then you can be 84 times levered with a Tier One ration of 7 per cent. [Figures: 1/(.17*.07)]. If a third of your tier one capital is subordinated debt (not uncommon in banking these days especially in the UK) then your total leverage ratio might be well over 100. I did this calculation for them and they were quite uncomfortable – because they are hardly wanting to telegraph to the rating agency that they will one day be 100 times levered. (It would increase the cost of their funds now and hence further compress their margin.)

I did not get any useful feed on where the limits to growth are. However looking at the other banks (discussion later) I suspect that the limit is roughly 60 times levered. That would suggest (growing capital at 15 and earnings assets at 25) that there are four to five years left. However by that point the bank has almost ₤200 billion in assets – large compared to the UK mortgage market. Its funding would be totally ridiculous. [Comment deleted because a senior executive of another UK bank thought Northern Rock would go bust in 2007. I just do not want to dump him in it.] Something will crack – but in five years earnings could double again and the stock could be an abysmal short.

If you look at the five year summary above you will notice that the mortgage originations in any year the gross lending is substantially larger than the net lending. In 2004 gross lending was GBP23 billion - about 45 per cent of the total managed book at the end of 2003. Asset growth is only about 45 per cent of net lending.

This leads into the way that the lending is done. Its TEASER RATE lending. In the UK new mortgages (especially from this bank) tend to have a “teaser rate” which applies for two to three years (mostly two years). The fashion of late is to have two year fixed rate loans on very low spreads (the yield curve is flat in the UK) and to offset the spread a little bit in up-front fees. The loans revert to old fashioned (and fat margin) standard variable rate (SVR) at the end of the teaser rate period. The profitability of this business is determined by how many of the loans you manage to keep on your books after the teaser rate wears off and on any incidental products you might sell to the mortgage holder. If the loan comes in through a branch rather than an IFA the loan might be more profitable because it does not cause a broker fee. Internet channels are also relatively profitable.

The way that Northern Rock grows so fast is that it is the king of the teaser rate. It has however very poor retention. Bradford and Bingley told me that Northern Rock would boast about their 400 retention staff (they will cut your rate if you ring up because the alternative is for you to go elsewhere and a cut rate loan is more profitable than a new brokered loan). The competition also target Northern Rock customers. Natwest (HBOS) have regular advertisements on TV showing people on a rollercoaster with very low mortgage rates about to swing up wildly (and quite graphically make them sick). They suggest that you are nuts if you take this swing up and offer you GBP100 if you are an Alliance & Leicester or Northern Rock customer (not a B&B customer) and your rates refinance and you do not want to pick a Natwest mortgage. Its clear that Natwest however is trying to get people through the (lower cost) direct channels. (This sort of competition exists in deposit pricing too.)

There is a test as to whether all this teaser rate activity produces long term customers. Just look at the implied fall off in loans versus the originations two years ago. In 2004 it appears that over GBP10 billion repaid. Gross lending two years ago was 12.5. There is clearly some but quite limited success in retaining the customers. When pushed on accurate data on this issue Northern Rock were simply not forthcoming.

There is one more thing that is quite revealing about Northern Rock – and that is the effect of International Accounting Standards (IFRS) on balance sheet and profitability. UK companies are being forced to adopt IFRS and whilst it is an issue with a lot of noise for many companies the differences are small. They are not small at the Rock. In particular IFRS requires that income and expense charged as a fee but which relates to some period gets amortised over the period. Now remember that the shift in the market has been from floating rate teaser products to fixed rate teaser products with high fees. The Rock has been booking those fees up front inflating earnings and book value. IFRS will (under the guidance given at the conference) reduce book value and earnings by about 10 per cent. (Leverage is probably closer to 47 times – and using a sixty times limit the company probably has only three years rather than five.) The company seems to think that IFRS is a bad idea (aren’t the fees cash). But I am never quite sure whether the mix of fees and spread has shifted driven by accounting considerations or whether its driven by the realisation that churn is going to remain incurably bad or get worse. (Obviously enough up front fees are a good idea if you are scared of churn.)

All of this was enough to make me pretty bearish on the stock. But it got worse. They simply stretched numbers to say what they do not. If it were not for the low standards of America I would say they lied – but I suspect just being economical with the truth was closer. I have referred above to the notion that their delinquency is half the industry average and therefore (as they argue) they deserve only half the regulatory capital charges of the competition. The problem is that a delinquency rate simply does not make sense when your growth has been as rapid as the Rock. I tried to tease out of them the notion of a “growth adjusted delinquency rate”. No luck. I tried to work out what the delinquency by age of mortgage was so I could do the numbers – no luck. They simply were not forthcoming and even attempted to mislead me.[5]

The place however they misled most blatantly was on the margins both historic and prospective. The company stressed that I should not just look at interest margin – rather I should look at fees plus margin over assets – especially as they had shifted to fixed rate low margin loans with relatively high fees. Ignoring the IFRS issue (as they did) the average margin on the book is 125bp and it has fallen every year – most notably during 2004. They wanted to tell me that the INCREMENTAL margin was 110-120bp. This is much higher than the competition tell me the margin is (40-80bps) and simply cannot be squared with the margin figures in the above table. The problem is that they will soon hit limit leverage constraints (but they would not tell me what those constraints were) and were aware that their margins (hence earnings and ROE) would continue to drop once they hit those limits.

As for credit risk. The company told me that they had a position in the broker market as offering the cheapest loans to the best credit. I have one reason to disbelieve them. The Rock has a lower rating and hence a higher funding cost than several competitors – and hence would naturally have a relative advantage further up the risk spectrum (its hard to do good credit well with a low rating). Also they told me in another breath that they had industry leading margins (which did not reflect in the accounts). Stuffed if I know. They seem to think that they will be alright with a 20 per cent fall in the property market. They seem to get concerned when you talk about a 30 per cent fall – and they seem to think that a 35 per cent fall is impossible. I heard all the old hoary clichés: “they are not making any more land in the South East” etc. I should get the stock brokers to organise me some chats with mortgage brokers and IFAs. But I am – until that – inclined to believe that the threshold for pain is about a 30 per cent fall in the property market – and that falls beyond this range could lead to a wipe-out because the loan book is new (hence has not had the chance to get much appreciation into it) and is so levered. [Ok – I was wrong here – they went bust on funding.]

You do have to give the bank credit for one thing though. They have got their costs quite low – 38bp of assets and probably lower under IFRS. This is one of the lowest cost structures in the world. The management will point this out as almost their crowning achievement. They had to do it (had they kept their old cost structure the squeeze in margins would have wiped them out). It does however look difficult to keep reporting lower costs – this looks a lean operation.

Do I want to short it? I wouldn’t object – but I suspect we can do better with timing. The investment bankers are convinced that if something went wrong it would be purchased at 80 per cent of book on the way down. Maybe that is true now – but it will not always be so. I was staggered by the lack of sophistication of the staff – I met the CFO and he was either dumb or a liar or just assumed I was dumb. This company is totally dependent on the goodwill of financial markets. I put to them that they were dependent on the kindness of strangers – and they bristled. They thought that people invested in UK mortgages because they were good investments. Why – so they thought would you invest in Italy?

For discussion.

[1] The shrinkage does not show in the numbers – but the deposit base includes €2.5 billion in French deposits which are really hot-money commercial paper and some Japanese deposits. The claimed retail deposits in the five year results page I reproduce (17239) does not match the balance sheet (20342) and I am assuming the difference is roughly the above €2.5 billion and other quasi wholesale money. I can’t tell how much “hot money” there is but Northern Rock were pretty keen to advertise a 5.4 per cent rate. The shrinkage is a guess – but the company was not far from admitting the same when pushed on the issue.

[2] Amazingly the CFO was prepared to name the six Japanese banks which purchased the paper. I told him we had an interest in the Japanese banks and it would help me understand their books. He did not remember their names but he had been on a roadshow to Japan. I have virtually never had a company volunteer this sort of information. Its pretty naïve to do so as there is more than one way to interfere with a banks funding. If he had thought about it clearly it was just as likely I was short Northern Rock than long it. It was part of a general attitude I came across in Britain (nobody appears at all concerned about the vulnerability of funding bases). I pretty well floored Michael Oliver (the very experienced IR guy at Lloyds TSB) when I told him this when I took him out to dinner.

[3] The US tends to have a regulatory limit on leverage at 20 times. Any further and the informal rule is that you can expect an intrusive visit from the regulator. [Some comments deleted here.]

[4] [Regulatory footnote removed – partly because it is wrong – and I am embarrased.]

[5] On the train between Leeds and Leicester I chatted to a woman in her fifties about the banks. She had a mortgage on SVR (an old high margin mortgage) with Lloyds TSB. I asked her why she did not refinance it and she told me a story about weakened credit. Her husband no longer worked and her income paid the mortgage and supported the family. She had plenty of equity in the house but she (erroneously) thought that she could not refinance. Refinance would have saved her GBP500 per year. It was an easy decision had she been informed. Lloyds is hardly going to inform her. But there is a lesson here – the back book are going to have higher delinquency than the front book but without necessarily worse credit. It self-selects this way in part. The comparison that Northern Rock had on their delinquency rate was at best grossly misleading. (There is a possibility that they believed it though which would suggest incompetence. In this case they misled so transparently they might well just have been dumb.)

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