Know Your Limits

On 14 September 2007, long queues formed across the UK outside branches of the Northern Rock bank, as anxious customers besieged the building society turned public bank, desperate to retrieve their savings.

Billions of pounds flooded out of Northern Rock, which turned for help to the Bank of England, and ultimately to the UK Government. It must have all made uncomfortable viewing for Jonathan Westhoff, the new finance director at Newcastle Building Society. But as Westhoff explains, unlike some other businesses, the Newcastle is well placed to ride out the current turbulence in the banking sector.

UNDERSTANDING RISK

The interesting thing about the sub-prime crisis, says Westhoff, is that it is yet another set of events in the financial world that should remind everyone of the most basic of fundamentals: you need to be able to understand your risk.

"If you think about it, the vehicles through which sub-prime lending was fuelled in the US – primarily securitisation and CDOs – were ones by which the investors were totally detached from the origination, and so they were reliant on rating agencies and didn’t necessarily have a great understanding of the risk that they were taking themselves."

"In fact you could argue," adds Westhoff, "with some of these sub-prime transactions, that there is no price you can set that will satisfy the risk. Technically you can try and predict the losses for most categories of risk, but eventually you reach a point at which an activity is so risky, there is such a high probability of going into default, that there is not a price that would justify originating the loan."

"The default rates for sub-prime in the States at the moment are probably in the region of five times the standard prime residential mortgage default rates, and probably head up into the region of 20% of loans going into default," he says. "When you consider those default rates, you cannot mark a margin on the lending that would cover you for that, you are going to make losses and some of these losses are going to be huge."

And it is certainly true that the fallout in a sub-prime market worth somewhere around $1.4tn has produced some big losses, albeit indirectly as a result of associated illiquidity in some of the more high-profile cases.

"Once you become dependent on a model, and the investors get frightened and disappear, it is the oldest story in the world, you run out of cash. That is the first thing to bring your business to its knees. Profits and capital are less important than cash," says Westhoff. "Looking at sub-prime, if you take investor’s required returns, the only way people are being able to satisfy those returns in a residential mortgage market is to go further down the risk curve to generate the high returns, and so you have this massive entrance into the sub-prime market."

Not that Westhoff is against financial innovation, but he does believe that transparency and a thorough understanding of innovative financial products is essential. "You can’t eradicate financial innovation; it has created lots of opportunity, and the consumer benefits from that. But financial innovation does not necessarily mean that it should be at a level of complexity that is unfathomable," says Westhoff.

"The simple answer is that if you can’t explain it and you can’t translate its complexities into risks, then the organisation should not be using it. The acid test is to understand the risks, and I would question, if you’re not able to communicate those risks, to the non-executives in particular, whether you should you be using those instruments."

Some commentators have also questioned the role of the credit ratings agencies in the sub-prime crisis and subsequent credit squeeze. But, as Westhoff says, the rating agencies perform an important function, and it is difficult to envisage workable alternatives.

In the current environment, it is all too easy to point the blame somewhere other than the body that obviously has the responsibility, and that is the lender.

"The ratings have always been flawed in one sense, much of the information they have is historical, or based on experience of default rates. When you move into markets like sub-prime as heavily as many other lenders have, you could argue that perhaps you don’t have robust enough data to be sure of the classifications of probabilities of loss and default that you are pricing in these instruments. It is a very difficult job."

RIDING OUT THE STORM

But while fear strikes investors and freezes interbank lending, not every building society or bank is equal when it comes to its exposure to the current financial crisis.

Westhoff explains the fundamental problems facing lenders at the moment and why Newcastle Building Society is less at risk than some. "Every institution in mortgage lending in this country faces the challenge of fulfilling the very purpose that building societies came into existence in the first place for – gathering in short-term funding via savings that are repayable on demand, and funding long term loans. The problem of that funding gap or transfer is not only nothing new, but in fact the reason the whole business started in the first place."

"The difference of course is how much you depend on the far more predictable retail saver who, regardless of using shorter term products, is saving for the long term. And that is far more certain, compared with the interbanking wholesale funding market."

The Northern Rock’s position was inverted compared to that of Newcastle, explains Westhoff. Whereas Newcastle will hold wholesale funding, it is more for the purpose of direct liquidity. "We have wholesale funding, that is non customer funding, of about 30%, primarily to provide a liquidity reserve of about 20% of all deposits," he says. "So most of what we hold that funding for is just to cover short-term cash needs in case the retail investor wants to take their money."

But in the Northern Rock’s case, and with some other banks, the figures can be heavily weighed in the opposite way. So 30% funding from the more predictable retail savings book, but 70% dependent on other funders. This is fine most of the time, but the other funders will have commitments of their own. They have interbank positions, liquidity provisions for Special Investment Vehicles, and so they may need their money back. Retail investors tend to want their money in far more predictable ways; in January to pay off credit cards used over Christmas, for example.

"So you get investment banks seeing the potential of the residential mortgage market and setting up more of these vehicles to warehouse these mortgages for a short while and then use their internal skills to securitise them," says Westhoff. "But once that model breaks down then they have got a funding problem and need to call back their loans to other banks that are doing the same."

Another important factor of the Newcastle Building Society’s business model is how it sources the non-customer deposit element of its funding.

"Even within the non-customer deposit portion, the wholesale funding element, we don’t rely heavily on banks. We would have significant deposits from non-bank institutions, whether directly from insurance companies, from long term fund managers, or from local authorities, but a very small proportion actually borrowed from a bank. So when banks pull funding back for their own balance sheets, it has very little impact on our business," says Westhoff.

The Newcastle has stress-tested for fairly extreme scenarios, says Westhoff. "We have always stress-tested on liquidity, against circumstances that would cause a large number of depositors to take their funds from us," he says. "That is why we hold such a high level of cash reserve, over 20% of all funds deposited with us, which is quite a high level to sit there, physically held in very short-term instruments or cash."

Interestingly, as Westhoff points out, BASEL II is primarily about adequacy of capital, but clearly liquidity is every bit as, if not more, important than capital. Capital is only there for when the first part is gone, hence the FSA and various regulators looking at enhancing liquidity stress-testing.

Having said that, it is reasonable to assume that each bank and building society will have their own suite of stress tests, and will have run them, he says. It is just that sometimes a scenario is so severe, that current stress-testing models are inadequate, so you have to revisit them and introduce even more severity.