Collateral damage, by Paul Gosling

4 Oct 07
he shock waves from Northern Rock continue to reverberate throughout the British economy. But what do the financial upheavals mean for public sector organisations and employees? Paul Gosling delves through the debris

05 October 2007

The shock waves from Northern Rock continue to reverberate throughout the British economy. But what do the financial upheavals mean for public sector organisations and employees? Paul Gosling delves through the debris

Whatever happens in the forthcoming Comprehensive Spending Review, the public sector has reasons to be very, very appreciative of Chancellor Alistair Darling. He has saved them from millions of pounds in losses.

Had Northern Rock collapsed – which looked likely – local authorities would have lost heavily. Local government in London alone had more than £50m on deposit with the stricken bank.

The Bank of England's intervention – giving Northern Rock access to a reported £8bn in emergency loans – followed by the chancellor guaranteeing the bank's deposits, did more than provide reassurance to the financial system. It was excellent news for institutions as well as individuals with accounts at the bank. Public sector pension funds have not been so fortunate – some have lost from the bank's collapsed share price and, to a lesser extent, falls in other banks' share prices.

The Northern Rock affair is a very modern financial crisis. Its cause is an interweaving of the impact of globalisation, the use of extremely complex 'financial engineering' and old-fashioned ambition on the part of the bank.

Northern Rock's origins are in the nineteenth century as two local building societies in the Northeast of England. The Northern and Rock societies merged in 1965 and took over another 51 societies. But the society's executive team had ambitious plans, involving its conversion to a PLC a decade ago. As its directors boasted to an all-party parliamentary committee, their subsequent expansion was possible only because of demutualisation.

While most mortgage lenders finance loans from deposits, Northern Rock wanted to expand fast. So it borrowed heavily on the international market for funds to put into UK home loans. But when international loans dried up after heavy defaults in the US's 'sub-prime' sector – loans to borrowers on low and doubtful incomes – the bank could not finance its immediate liabilities.

Instead, it had to go to the Bank of England for emergency funds. The Financial Services Authority issued assurances that Northern Rock's underlying solvency was not in doubt. But that could change, as the bank has other problems. It issues mortgages on the highest loan-to-income ratio of any lender (5.9 times income) and equal highest loan-to-value (up to 125% of home value). This helped stimulate the house price boom and makes the bank vulnerable if prices fall. Now Northern Rock earns a lower rate of interest on home loans than it pays to the Bank of England, or is available on the international market.

Other banks suffered too from the financial crisis, with falling share prices. Two German banks had to be rescued; the largest US mortgage lender, Countrywide, is in difficulty and the second largest sub-prime lender in the US, New Century Financial, is in bankruptcy protection. Two hedge funds have gone bust.

But other hedge funds have done well. (The term 'hedge fund' covers a variety of alternative investment strategies – only a small proportion back US sub-prime loans.) Several funds have made massive profits by 'short-selling' Northern Rock shares – 'renting' them from institutions, selling at high prices and buying back after the share prices fell.

These profits came at the expense of the bank's shareholders and would probably have been at depositors' too, but for the government's guarantee. The Metropolitan Police Authority, the London Fire Authority and the Greater London Authority each had several million pounds in Northern Rock deposit accounts.

A spokesman for the MPA told Public Finance last week: 'The MPA currently has £39m invested in Northern Rock, £29m of which matures this month [September], the remaining £10m in November. This is 12% of the total monies invested by the MPA in various financial institutions.'

A GLA spokeswoman says that it had £5m on deposit at the bank, which represents 'only a small proportion of funds' currently invested. She adds: 'Our deposit with Northern Rock was made on Wednesday, September 12, before any hint that it might have serious liquidity problems and before its credit rating was first reduced on the Friday, at which point it would not have met our criteria for lending and therefore no further loans would have been made.'

Both the MPA and GLA stress that cash balances are invested in accordance with CIPFA's Code of Practice for Treasury Management and they only use institutions with a high credit rating – which, ironically, Northern Bank had.

A spokesman for Northern Rock confirms that 'several public bodies have cash with us in the form of time deposits and they are covered by the Treasury guarantee'. But he adds: 'The amounts are not in the public domain so are we are not allowed to disclose them.'

CIPFA's local government treasury management specialist, Alison Scott, says that it is 'highly unlikely' that any council would lose money held on deposit with Northern Rock, despite the Treasury guarantee not apparently applying to bonds. Northern Rock's statement implies that no public body holds bonds issued by the bank.

Scott says the code of practice was designed to cap individual local authorities' exposure to risk by limiting the amount of money that they could place with any one institution. The code specifies that only organisations with good credit ratings can be invested in and that cash flows have to be effectively managed, including through the use of money market and capital market transactions.

Most NHS trusts are more restricted in their use of cash reserves and balances. Trusts' balances above £50,000 must be held on deposit with the Department of Health, not in a bank account. Foundation trusts, which had about £1.3bn in spare cash at the end of the past financial year, have more freedom over where they hold money. However, Monitor – the foundation trust regulator – is confident that none has any funds on deposit with Northern Rock. Trusts are required to notify the regulator if they have any assets at risk and none has done so.

Public sector pension funds owning Northern Rock shares have lost badly – shares lost over 85% of their value. Investment fund manager Baillie Gifford, which manages many pension funds, has been one of the biggest losers. It is estimated to have lost about £250m. Its literature says it manages money for 'some of the country's largest corporate, local authority and charity funds', including Cheshire County Council and the University of Edinburgh – but the company declined to name other public sector clients. Cheshire failed to respond to our request for an indication of how much, if anything, its fund has lost.

Given Northern Rock's importance to the Northeast of England, the most vulnerable local authority pension fund might be Tyne and Wear's, which covers Newcastle and Sunderland city councils. A spokesman for South Tyneside Council, which administers the fund, says: 'Its current exposure to Northern Rock shares and bonds is £400,000, which represents 0.01% of the fund's assets.'

Funds might also be exposed to losses through investments in hedge funds – with many local government pension funds now holding stakes in 'funds of hedge funds'.

South Tyneside Council says it has 'no direct exposure' to the sub-prime problems, including through hedge funds. A spokeswoman for Leicestershire County Council, which appointed a manager of a fund of hedge funds – Fauchier Partners – in April, says: 'We are told that with the hedge funds in which we invest, there is no adverse effect from problems in the sub-prime market.'

Emily McGuire, head of the local government investment team at pension adviser Hewitt Associates, says: 'There has been an awful lot of talk and interest in the local government market in hedge funds. They [local government pension funds] have historically had a high proportion in equities and are trying to diversify.' But while several funds now invest in hedge funds, with more to follow, McGuire says that their total investment will be only 5%–10%, limiting their exposure to any losses.

John Hastings, a partner in the investment practice of Hymans Robertson, says public sector pension funds' exposure to sub-prime loans and related investments is 'pretty tiny'. 'Actually, not that many local authority pension funds have that much hedge fund exposure,' he explains.

'Across the UK, the last National Association of Pension Funds survey found only one in six pension funds had any exposure to hedge funds. Those that did had only 5%–6%. So the whole exposure is less than 1% of pension fund assets.' In fact, he says, the total impact on pension funds might be positive because of the change in the pricing of bonds and loans. Yields on corporate bonds are rising by about 0.4%, increasing pension funds' income.

Divyesh Hindocha, a principal at pension consultancy Mercer, shares this analysis. He says there is generally 'very little' exposure by UK pension funds in the sub-prime housing market, but adds: 'We don't know for sure.' 'The biggest problem,' he argues, 'is the impact of the abnormal financial conditions on the real economy and the subsequent impact on equities.'

As yet, it looks as if any impact on the government's affordable homes strategy is marginal. Northern Rock does not finance social housing capital investment or housing association shared-ownership schemes. However, Bradford & Bingley, which is a financier of housing association capital schemes, saw its share price fall badly following Northern Rock's disclosure of problems – even though it is not as reliant on borrowing from the international markets.

Another bank badly affected by falls in its share price, Alliance & Leicester, is one of the major lenders to housing association tenants moving on to shared ownership. If its problems get worse, the availability of these specialist loans could be affected. Tenants seeking right-to-buy loans will probably be affected as lenders' criteria are tightened. (Alliance & Leicester, however, has just increased the loan-to-value ratio it lends on. Others are unlikely to follow.)

There remains a sense of uncertainty hanging over the financial markets, which might stay for some time – perhaps influencing the prospects of an autumn general election. The implications for the wider UK economy and the CSR are not good. The cost of borrowing is already rising, the housing market is slowing down, consumer confidence will presumably drop and the government's tax receipts will fall. With less revenue coming into the Treasury, the public sector is even more likely to face a tough cash settlement. A CSR that was already expected to be very tight could put a heavy squeeze on much of the public sector.

Amazingly, seven months after the sub-prime crisis started to hit the US, financial institutions around the world still do not know their level of exposure to the losses. This has led to Alistair Darling's initiative to promote more transparent international accounting practices. But the uncomfortable truth is that although we have started on a journey, no one really knows where it will take us.

PFoct2007

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