Northern Rock - who's to blame?

The near-collapse of Northern Rock is one very public outcome of the credit crisis now tearing through a once-arcane corner of the markets. But who's actually to blame for the queues on our high streets? John Stepek and Eoin Gleeson consider six suspects.

Adam Applegarth, chief executive, Northern Rock

Six months ago, Northern Rock chief executive Adam Applegarth was riding high. The bank's shares were scaling new heights and Applegarth was, as The Independent's Jeremy Warner puts it, the "banking sector's pin-up boy". For those queuing outside branches of Northern Rock last week, however, Applegarth has become more of a hate figure than a hero. But is he really the Number 1 villain in this crisis?

Starting out at as a cashier at Northern Rock as a young graduate, Applegarth described himself as "naturally clumsy", accidentally standing on the silent alarm button under the counter at least once a day. It didn't hurt his promotion prospects: by 2001, aged just 39, he'd become chief executive. His strategy was to undercut deals offered by rival banks by making the system as efficient as humanly possible. "He might just as well have been managing a sandwich factory," said Richard Fletcher and Philip Aldrick in The Daily Telegraph. "The bank has one market, the UK, and one product, mortgages."

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Customers snapped up the cheap rates on offer and Northern Rock quickly became the UK's fifth-largest mortgage lender. But financing its ambitious growth plans required a level of funding that no building society could get its hands on. So Northern Rock went to the money markets, with customer deposits eventually accounting for just 25% of the bank's funding. So when the US subprime housing problems reared their ugly heads, and banks stopped lending to each other for fear of exposure to bad debts, Northern Rock's chief source of funding completely dried up, forcing it to go to the Bank of England for an emergency loan.

That panicked customers, and the queues that formed in turn panicked the government, which stepped in to guarantee the deposits of every saver. That move seems to have eased the pain for now, though it has set a dangerous precedent. But while Applegarth was pursuing a particularly high-risk strategy, Northern Rock's problems are by no means isolated. The seizure in the interbank-lending markets have hurt every bank, to some extent. So who created the environment that enabled banks to behave so recklessly?

Margaret Thatcher, prime minister, 1979-1990

Margaret Thatcher's recent tea party with Gordon Brown may have been "more symbolic than the prime minister's image makers realised", says Larry Elliott in The Guardian. "It was Mrs Thatcher who paved the way for today's crisis through financial deregulation and deindustrialisation," says Elliott. It's fair to say that even though the Tory party hasn't been in power for the past decade, it has certainly played a big part in shaping the way that Britain is today.

Thatcherism brought many benefits, such as breaking the trade unions' grip, while the Big Bang of 1986 was the key to turning London into a global financial centre. But some argue that Thatcher's reforms resulted in an overreliance on the financial industry. "How stable is an economy where the twin engines of growth are consumer debt and the speculative activities of the City?" asks Elliott. "Any seize-up of global financial markets affects London and the British economy more than any other," argues Charles Dumas of Lombard Street Research. But it's highly debatable that deregulating the City is itself the cause of current problems. For one thing, the same deregulation that enabled the financial innovations that threaten us also opened up investment in markets to the public in a way that had not been imaginable before. And calling for more regulation, as Chancellor Alistair Darling has, is "depressingly predictable and pointless," says Warner. Banks are already learning their lessons. If anything, new regulations will "likely help create the next crisis".

Gordon Brown, prime minister, chancellor 1997-2007

In any case, the one person who has had the most influence over the economy over the past ten years has not been Maggie, but Gordon Brown and after years of waiting to become prime minister, the last thing he wants is to be associated with a very public economic crisis. So we've barely seen him for days. At the first hint of the foot-and-mouth problems he was chairing crisis meetings on TV. This weeks he's stayed in and sent poor Alistair Darling into the fray. No doubt he knows that, as Anthony Hilton puts it in the Evening Standard: "The one thing that would certainly cost Gordon Brown the next election would be the collapse of his reputation for sound management of the economy." David Cameron and the Liberal Democrats have already pointed the finger of blame for Northern Rock's woes directly at the former chancellor.

Here at MoneyWeek, we've never been big Brown fans. This has nothing to do with politics, and everything to do with economics. Under his "prudent" gaze, the British consumer has racked up £1.3 trillion in debt. Public spending has rocketed, while his attacks on pensions the £5bn-a-year raid launched by scrapping the dividend tax credit have helped drive investors into property, forcing first-time buyers off the ladder to be replaced by buy-to-let landlords. This promises to make the coming housing market downturn horrible. None of this appears to have lost Brown much sleep until very recently: he has long maintained that the economy is not in the midst of a volatile credit-fuelled boom, but that it is showing the stability one would hope for after ten years of prudent management. Our guess is that fewer people are buying that spin this week than were last week. But while Brown is responsible for many things by spending far too much in the good times, he has left the UK economy vulnerable to the global credit crisis he isn't actually responsible for the sub-prime crisis, nor for the resulting credit crunch.

Mervyn King, Bank of England governor

So what about the other key figure in our economy: the governor of the Bank of England? Mervyn King has taken a lot of flack for his handling of both the Northern Rock crisis and the problems of the interbank-lending market freezing up. Christopher Wood at CLSA reckons he should have let Northern Rock go to the wall; most feel he should have done more to help the banking system in general.

But as Hilton says: "it is astonishing that anyone in the City or Westminster could have the audacity to suggest that the Bank of England or the Financial Services Authority were asleep at the wheel' and somehow to blame for the collapse of Northern Rock." King along with the FSA, the IMF and countless think tanks has warned several times in recent years that banks have taken on too much risk. And after those warnings, he clearly felt that banks should pay at least some penalty for carelessness. Unlike the European Central Bank and the Federal Reserve, the Bank of England initially refused to pump extra money into the system. It intervened with emergency help when Northern Rock was on the verge of bankruptcy, and even then only because it had no real choice: the political ramifications of a run on the bank outweighed economic considerations.

With the government overriding the Bank, by promising a full taxpayer-backed bail-out of Northern Rock and any other bank that goes bust, the Bank's independence has gone out of the window, along with much of King's credibility. Worse, if a scapegoat needs to be found for the crisis, it could well be King: his post comes up for renewal in November, the perfect time for the government to cast blame. It's a shame, as his approach was the right one. But as Philip Stevens puts it in the FT, "as King has discovered, being right can also sometimes carry costs".

That's not to say that the Bank hasn't made mistakes. The rate cut in August 2005, which helped reflate the housing bubble and encouraged lenders and borrowers to believe that prices would never fall, was a mistake. But to be fair to King, he voted against that cut. And besides, if rates were too low here, they were positively rock-bottom on the other side of the Atlantic where the whole subprime issue that paralysed the money markets begain in the first place.

US sub-prime borrowers

The crisis in credit markets has its roots in the simple fact that many people in the US borrowed money to buy houses they couldn't afford. So if we're looking to blame someone for the credit crunch, perhaps we should look to the US's trailer parks and condominium developments. Last year, about one in five mortgages taken out in America was subprime. Innovations included the Ninja loan for people with no job, and no income or assets. A large proportion were adjustable-rate mortgages, where borrowers were offered low "teaser rates" and told they could remortgage against the rising value of their home once the low-rate period was up.

Unfortunately, in 2005, house prices began to fall, while interest rates kept rising. And that was when people found that not only could they not afford their mortgage bills; they couldn't find anyone to refinance their mortgage either. And so repossessions have climbed steadily, hitting a record high of 0.65% of all loans in the second quarter of this year. More than one in 20 mortgage-holders are now behind on their payments, and some estimates suggest that 2.2 million Americans could lose their homes by the time the crash has played out.

Of course, people should have known that house prices don't defy gravity for ever. And yes, some mortgage applications were downright fraudulent. But what kind of lender would think a Ninja loan was a good idea? Only one who didn't care whether or not they got the money back. And here is the crunch. The reason they didn't care was because loans were being taken off their books by investment banks, who turned them into bonds, which were sold on to hedge funds and pension managers. What made it all possible was that the ratings agencies gave the final products the now-notorious CDOs (collateralised debt obligations) top credit ratings, enabling the most risk-averse pension funds to pick up a few without compromising their investment strategies. "It's triple-A rated," they thought. "What can possibly go wrong?"

So perhaps instead of blaming the borrowers we should blame the banks? Maybe. But we are inclined to take it one step further, and ask how the financial industry lost its sense of risk in the first place. What drove the quest for higher yields to the point where people who should never have been allowed to borrow to buy a car, let alone a house, were having money thrown at them? It was all largely down to one man: celebrity central banker, Alan Greenspan.

Alan Greenspan, Federal Reserve chairman, 1987-2006

Alan Greenspan has been more than happy to apportion blame for the subprime crunch. It was "an accident waiting to happen", he told The Daily Telegraph this week. He listed the people he says are to blame, including George Bush, who he says has been too profligate with tax cuts. But perhaps Greenspan should take a harder look at himself. Because the truth is that it is largely his fault. By cutting interest rates in the wake of every crisis to hit Wall Street, he created "the Greenspan put" the idea that whenever trouble threatened, the Fed would cut rates, flood the system with money, and thus protect investors from any mistakes they made.

This policy reached its nadir in June 2003, when rates were slashed to 1%. Such low rates (which were negatively adjusted for inflation, effectively penalising saving) set the scene for a debt-fuelled consumer boom, and drove investors to find riskier assets to deliver better returns. So Greenspan created a world in which subprime lending thrived. At the time, he praised it. "Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognised borrowing capacities."

Yet the former Fed chief should have known what he was doing. Back in 1966, he wrote a paper in which he blamed the Great Depression of the 1930s on the Fed pumping too much money into the economy during the 1920s. The excess credit "spilled over into the stockmarket, triggering a fantastic speculative boom by 1929 the speculative imbalances had become overwhelming." Greenspan now acknowledges, grudgingly, that rates may have been driven too low under his tenure. "We wanted to shut down the possibility of corrosive deflation. We were willing to chance that by cutting rates we thought might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address."

An inflationary boom, in the form of soaring house prices, is exactly what the US got and now it's his successor Ben Bernanke who has to deal with the consequences. The obvious way out is to cut interest rates and that's what he did this week, slashing rates by a half point. Trouble is, even Greenspan now believes that cuts will no longer work. According to Richard Ehrman on the The First Post, he now believes as do we that as Chinese exports become more expensive, and developing economies push prices for raw materials higher, inflation will once again become a threat. And that means higher, not lower rates are going to be needed. As Ehrman puts it, "we have been here before. In the 1970s and 1980s we were squeezed between rising prices and falling growth, and miserable it was too. It was called stagflation, and if Greenspan is right, it could be on the way back."

Northern Rock's board: what were they thinking?

While Adam Applegarth may be the main architect of Northern Rock's risky strategy, he wasn't acting alone. The chairman Matt Ridley has been conspicuous by his absence since the debacle unfolded. Dr Ridley is a zoologist, a best-selling popular science author, and a former journalist for The Economist. As one of the bank's major shareholders told The Times, that makes him "an unusual guy to be running a large company: he's not a businessman". But there was plenty of City experience among those sitting under Ridley which may have many wondering why no one noticed the danger the bank was in.

Directors include Nichola Pease, the chief executive of JO Hambro Capital Management. "Finance is in her blood," says The Guardian. "Her family was one of the original partners in Barclays", while, with a combined wealth of £283m, Pease and her husband Crispin Odey have been described as the "Posh and Becks" of the City. She receives a salary of £65,000.

Sir Derek Wanless, who chairs Northern Rock's risk committee, is one of a clutch of business gurus that Gordon Brown can turn to in a crisis, says the Daily Mail. As the former chief executive of Natwest, Wanless has previous experience with banking crises: he was the driving force behind a string of ill-fated acquisitions that seriously weakened the bank, ultimately leading to its takeover by Royal Bank of Scotland. Northern Rock pays him £86,000 and he holds 20,500 shares.

Sir Ian Gibson is "one of Britain's most prominent businessmen," says The Guardian. Gibson was the first European to be a senior vice-president at Japanese carmaker Nissan. He is chairman of Trinity Mirror, and was a member of the Bank of England's governing body for five years so you might have expected him to realise there was something amiss with Northern Rock's business model. Gibson is the senior independent director, earning £80,000 and holds 15,000 shares.