The FSA fines 2 ex-directors of the failed bank for concealing bad loans.
Just when you thought the financial after-shocks were over, up pops another credit-crunch headache for investors and regulators...
Northern Rock buries bad loans
On Tuesday, City watchdog the Financial Services Authority (FSA) fined two former Northern Rock executives for reporting false figures for mortgage arrears.
David Baker, once the Rock's deputy CEO, has been banned from banking and fined a whopping £504,000, which is reckoned to be the second-biggest individual fine ever handed down by the regulator.
His ex-colleague, Richard Barclay, the Rock's former credit director, was banned from senior positions and fined £140,000 for misleading the bank's management, shareholders and investors as to the true extent of the lender's mortgage arrears.
These penalties would have been even higher, but for Baker and Barclay pleading guilty in return for a 30% discount on the initial fines. Baker left Northern Rock in May 2008 and Barclay followed him only last month.
What did they do?
Barclay oversaw the Rock's Debt Management Unit (DMU), which started to see a steep rise in mortgage arrears during 2006. Northern Rock had a target to keep its loan arrears below half of the national average, so this put great pressure on its DMU.
Thus, instead of reporting this worrying trend, Barclay dropped 1,917 'pending possession' loans from the Rock's reporting. Thus, though the Rock reported 662 'possession pending' cases at end-2006, the true figure was 2,579 -- or almost four times as much.
Despite knowing the true position, Barclay's boss Baker then reported the false figure in a conference call about mortgage arrears in January 2007. Instead of reporting reality to the bank's board, Baker wrongly decided to wait six months, hoping the situation would improve over time.
This mis-reporting had the effect of reducing the proportion of Northern Rock mortgages three or more months in arrears at the end of 2006 by almost two-fifths (38%) from 0.68% to 0.42% of total lending. The Council of Mortgage Lenders average at the time was 0.89% and, thus, the Rock had overshot its arrears target.
In addition, the DMU 'capitalised' mortgage arrears and penalties by adding them to outstanding mortgage balances and reclassifying them as performing loans. By doing this for around 1,600 loans a week, the Rock massaged its arrears figures even lower.
Although neither executive made any personal financial gain from their cover-up, Baker and Barclay hid the true extent of the Rock's growing arrears from its stakeholders. Hence the stiff penalties levied on them by the FSA.
The 'riddle of the Rock' resolved
Reporting false arrears did not kill off Northern Rock. Ultimately, it was the Rock's reliance on wholesale markets for 70% of its funding which caused its liquidity crisis. This made the Rock the first victim of the summer 2007 credit crunch. It led to a run on the Rock in mid-September 2007 that brought the Newcastle-based lender to its knees in brought about its nationalisation in February 2008.
At last, this news explains a mystery which I started worrying about five years ago.
How on earth could Northern Rock undertake such risky lending -- including 125% 'negative equity' Together mortgages and loans of up to six times income -- without reporting higher arrears than its more cautious rivals? Also, how was the Rock growing so fast, grabbing a fifth (20%) of new mortgage lending in the first half of 2007 and beating giants such as the Halifax?
The simple answer is that the Rock was 'cooking its books'. By failing to provide a true and accurate picture of its financial position, the lender had set out on the road to ruin. Now we know the answer to the 'riddle of the Rock'!
More missing mortgages?
The obvious question investors and regulators will ask is: is the problem at Northern Rock just the tip of the iceberg? In other words, could there be problem loans going unreported at other national or specialist mortgage lenders?
Of course, more reporting breaches are certainly a possibility, especially at lenders which lack sound financial controls. Hence, further revelations of this type are certain to be accompanied by fines and the naming and shaming of individuals who have bent or broken the rules. Northern Rock's may be the first bad-loan scandal, but it won't be the last.
Alas, this creates yet another 'unknown unknown' for investors in UK banks. Banks' reports and accounts are difficult enough to interpret without wondering what's being 'left off the books' in order to gild the lily. As billionaire investor Warren Buffett warns: "It's only when the tide goes out that you learn who's been swimming naked."
Thus, poor financial controls, target-chasing, management pressure and bonus-based moral hazard (especially pre-2008) could mean more bad home loans hidden in lenders' cupboards. I certainly wouldn't bet against it, as there is never only one cockroach under the fridge.
And finally...
What impact will this revelation have on the government's plans to dispose of its 100% stake in Northern Rock? First, potential buyers will greet this cover-up with concern. Second, it will mean more painstaking due diligence will have to be undertaken on the Rock. Third, more money may need to be invested in order to improve its arrears management and financial reporting.
In short, this scandal will have lowered the Rock's attractiveness -- and its price tag -- for bidders. Thus, the Conservative plan for an early sale of state stakes in banks could take longer than planned. In addition, if this does prove to be the tip of the iceberg, then the Tories' aim to replace the FSA may have to wait until the mortgage market has been cleaned up.
More from Cliff D'Arcy:
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