Wednesday, September 7, 2011

Repost: My old notes on Northern Rock

This is a post I made fairly early in the history of the blog - and a post I think should have got more attention. (The original post had no comments and nobody much link to it.) I re-read it today (because it came up in conversation). I am kind of proud of it - so allow me the luxury of a repost.


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.)


Anonymous said...

The "what kind of customer" question is actually a pretty hot one - look no further then the recent Groupon talks. While it's obvious that some kinds of promotions - like the promo mortgage rates - tend to attract more of what companies call "low-margin" (and a customer in us would just call "budget-minded") people, the actual hard data on the effects of this phenomenon is hard to come by. Companies doing that kind of promotions claim absolutely wild dance of retention rates and subsequent total profitability of customer base acquired with "hey, cheap"-kind promos.
And very few publish solid, accurate results.

Just two weeks ago I canceled one of my cards when 2-year "promo terms" period expired. Talking with bank clerk was enlightening. He tried to keep me on with all sorts of arguments, down to "show us some gratitude" one:) I managed to drag that convo to informal and he revealed the whole bunch (they had a promo runnign for a year where an existing customer is offered a credit card with no service charges, 3-month grace and hilariously low rate for two years after signup, afterwards it basically reverts to a melon) was a total disaster - not only very few people stay on, but many are reluctant to further use any of existing offerings because it's not as good as they had (indeed, that was my whole point, thanks Lord banks compete pretty harshly in Russia). Now - bear with me - them clerks have a special bonus in the amount total of $500 (some special conditions, but still) for persuading people like me to stay on. I did a quick math, and that's over 1/3 of what the bank hopes to earn on my card on the normal year, provided i keep to my usage pattern. And the thing is, I still left, while just keeping my old "lux" terms would still entitle the bank to some earnings without need to offer exorbitant bonuses to stuff for BSing me.

I really have little experience looking at it from a "balance sheet" angle, but from the business angle, it's obvious they flopped the simple marketing math on all counts. And then, I'm working on the project where "to do or not to do the cheap-ass promo" is one of cornerstone questions. And the obvious math of it gets stuck at "expected retention rates" part. Need I say, the bank I spoke about earlier never published theirs, too? ;)


Anonymous said...

I read it several times. Should I be posting null responses?.

You also did a good post on Gold deflation\inflation which I think Krugman's posts adds well to

My specialist subject on master mind is "Bronte Capital 2008-2011 and how it relates to all 3 star wars triologies".


Anonymous said...

Another great write-up John - high quality analysis.

What multiple of book were they trading at at the time? The only possible small quibble one could make with the logic is that growing equity at 15% and assets/risk at 25%, you will indeed eventually top out your leverage ratio and not be able to grow, UNLESS you can raise equity at a steep enough premium to book.

This of course doesn't detract from the core conclusions of the analysis.


dearieme said...

"Natwest (HBOS) have ...": congratulations on not correcting this.

Anonymous said...

Northern Rock was the first to fall. It would have been reckless to make a lot of money on the first domino falling, because the bull market could have run a couple more years. Small amount of money allocated to low probability negative event bets is ok, but not a big bet.

In my opinion, the time to short is when the first couple of dominoes have already fallen. Then one can bet in size and it's less risky -- as long as one backs off when it looks like the world is going to end.

(Always easier to say what to do after the fact, of course.)


John Hempton said...

The Natwest/HBOS error was my notes written on a train.

Thanks for noting that it was not corrected. But hey - I wrote this on a laptop, jetlagged and trying to (a) look out the window irregularly and (b) survey random people on the train about the mortgage market to see if my retail understanding was right.

There are plenty of errors - including a doozy of regulatory stuff - in which I name names incorrectly in my internal notes. (I took that error out to protect the innocent - errors that protect me I leave in...)

AW said...


I met with them as a potential provider of recap equity shortly after their nationalisation. I will never forget the CFO describing Northern Rock as a 'Rolls Royce operation and the only issue was that it had just run out of petrol'.

BlackRaven said...

John, I don't understand why the CFO being happy to tell you which Japanese banks had bought their paper would be such an issue?

Anonymous said...

How did you do this type of research? By calculating ratios?

John Hempton said...

In Northern Rock's case by reading and understanding the numbers.

They were straight forward with the numbers. It was the interpretation of the business that was the issue.


dearieme said...

I wasn't being sarcastic - I was congratulating you on not being so vain as to correct unimportant errors long after the event.

Anonymous said...

Where do you get your experience from? From a finance textbook? From your education? Or a book from Amazon or Barnes and Noble? Or even a gut feeling?

I know that the housing market went down when people finally started to think that the prices were too high. Then the rates on the adjustable mortgages went up. So the people that got a loan with no money down could not afford their payment. I guess the job market became bad because investors lost money on their investments in seconds and real estate and the people that gave seconds were generally wealthy upper class people like doctors, etc. When they got losses, they also reacted by selling their shares, however a lot of other people started to do the same so the prices went down a lot. Plus these individuals that have small businesses decided not to hire because of their recent losses. Then the media and their hype added to the perception that everything was going downhill for the economy.

New business people had and are still having difficulty getting loans because the banks suffered many losses. This does not allow small business to hire and innovate as much. Big business CEOs seem to focus on profitability so they made business decisions to cut back on their workforce and hire overseas or increased current productivity. They also don't have to pay more because of the perception that the economy is super horrible.

The federal reserve cut the interest rate to rates like Japan. This allows the banks to have a bigger spread. However banks now are very risk averse. However this is kinda ridiculous because the profits are higher since they have a higher spread. All banks have to do is make loans that are not risky. In fact they can make risky loans because the probability is that there will be appreciation now in housing and commercials properties since what appears to be the bottom has now passed. Anyway if more people buy, property values will increase anyway. The banks that make the first loans now will have the lowest risk considering that values go up later on.

People will and should start to realize that the economy is not so bad like the media portrays it.

John Short ad sinorazum said...

I know a guy supposedly sold his stocks in 2007, because he realized American banks were amortizing future profits and pumping up earnings that way. He figured that this accounting was a scam and thought there would come a financial crisis. Not sure if this info is right, this guy is not a good trader, as he was continuously short the 2009+ bull market, but maybe his fundamental perspective is sound.

Phil said...

John, I don't understand why the CFO being happy to tell you which Japanese banks had bought their paper would be such an issue?

Because an investor who was heavily short could use that information to go after their funding sources & possibly convince them to pull their funding?

As John says, it's a sign that the whole of the UK was locked into a bubble mentality at the time: the possibility that the person they were talking to might actually want to go short rather than long didn't even occur to them.

Tim Worstall said...

All most amusing: for I know (vaguely, it must be said) the bloke who was Chairman at this time and he's since admitted that he was wildly out of his depth.

The right sort of Chairman for a regional building society, not the right one for a bank going so aggresively for growth.

Anonymous said...

to be fair to yourself, you should also re-post one where things went all completely against you(r thoughts).

John Hempton said...

There were very few disasters (blessedly) though buying Ambac for the bounce and not selling much of it when it had the bounce was bad. But not disastrous - slightly worse than broke even.

And buying the preferred shares of Washington Mutual - well that was disastrous.

Both were blogged about.


Anonymous said...

Could someone tell me where i'm wrong here. I thought Northern Rock fell over because it had large short term loans which it had to roll over early in the crisis. At this point there was simply noone lending because of the market panic and Norther Rock could not roll them over. The problem was not the repayment of the mortgages which was actually pretty stable, but the fact they simply couldn't roll over their loans.

Is this incorrect ?

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