Northern Rock - an interesting angle

The Northern Rock debacle has many strands to it but one that I thought needed investigating was the management of risk. I have carried out a bit of digging on Northern Rock's risk compliance with particular regard to the implementation of Basel 2. Basel 2, which oddly enough replaces Basel 1, implements a "New Capital Requirements Framework" on financial institutions. I am only interested here in the implications on mortgage lenders so you might want to look at this from the Council of Mortgage Lenders. I would recommend you looking especially at points 12 & 20. Some key phrases that should be noted are:

a) "As residential mortgages traditionally have one of the lowest rates of credit losses, mortgage lenders already hold less capital relative to their asset size than most other lenders under Basel I (mortgages carry a 50% risk weight, against 100% for unsecured personal and corporate loans).

Basel II further recognises the safety of residential mortgages by reducing their weight under the standardised approach from 50% to 35% for loans with a loan-to-value ratio (LTV) of up to 80%"

Yes you read that right, Basel 2 means that mortgage providers are deemed a lower risk than other lenders and so need lower capital cover.


"On average, it is thought that mortgage lenders could be the largest beneficiaries of Basel II, seeing capital requirements falling relative to other lenders."

"Residential mortgages is the only asset class that is widely expected to see a general reduction in risk weighting under Basel II, which should mean that mortgage lenders, with the exception of those holding the riskiest loans, should experience a reduction in capital required"


Basel 2 could be implemented anytime between 01.01.07 and 01.01.08 and during this period banks have been implementing it depending upon their internal systems and priorities.

So have Northern Rock already implemented Basel 2? Bearing in mind "that mortgage lenders could be the largest beneficiaries of Basel II", you will not be surprised to learn that they have indeed done so earlier this year. "On 29 June 2007, we received notification of approval by the FSA of our Basel II waiver application. Our regulatory capital requirements, comprising both Pillar I and Pillar II, are therefore calculated under Basel II with effect from that date."

From the Northern Rock "Interim Results for the six months ended 30 June 2007" published on 25 July 2007 we learn that (my emphasis) "We are pleased to have achieved approval for use of our Basle II rating systems. This means that the benefits of Basle II enable us to increase our 2007 interim dividend by 30%. Going forward our dividend payout rate increases to 50% of underlying EPS from around 40%. Future capital planning, including the reduction of capital hungry assets, will allow us to return capital to shareholders through a share buyback programme. .

The interim report also contains this line "The medium term outlook for the Company is very positive" which is interesting in retrospect!

Some other points from the interim report which may be of interest are:

"The implementation of Basle II results in our Pillar I risk weighted assets at 30 June 2007 falling from around £33.9 billion under Basle I to £18.9 billion under Basle II, a reduction of some 44%. The risk weighting for our residential mortgages reduces to mid-teens %, treasury assets to around half of Basle I requirements, also around mid teens %, reflecting the low risk nature of these portfolios and personal unsecured loans to slightly below Basle I requirements."

"The introduction of Basle II, together with the planned disposal of capital inefficient assets and continued capital management such as the Whinstone programme results in an anticipated regulatory capital surplus over the next 3 to 4 years. This surplus will enable the reduction of previously planned subordinated debt issues and permit capital repatriation of up to £300 to £400 million over this period. Such repatriation will follow the release of capital as a result of asset disposals and will ensure that available capital is sufficient to support existing rating agency credit ratings and maintain an appropriate mix of Tier 1 and Tier 2 capital."

"The introduction of Basle II, which requires less capital to support new lending, also enables a review of the Company's dividend policy. It is proposed that for 2007 and beyond, dividends will be maintained at a payout ratio of around 50%. The interim dividend therefore increases by 30.3% to 14.2p (2006 - 10.9p) payable on 26 October 2007 to shareholders on the register on 28 September 2007."


The FT commented on this interim report thus (my emphasis)"Last month's profit warning spooked the market and highlighted that Northern Rock's reliance on wholesale funding carries some risks. Certainly the bank's earnings growth in the next 18 months is likely to be more subdued and there will be a further squeeze on net interest margins, a key measure of profitability, which dropped to 68 basis points in the first half. However, prospects for the longer term look much better. Northern Rock will benefit from share buy-backs and will see earnings bolstered as it retains more new customers. The shares may also benefit from speculation that Northern Rock will be a takeover target. Collins Stewart puts the bank on 8.2 times 2008 earnings, which seems reasonably priced."

Hmmm...


Any thoughts?