Northern Rock in a hard place

The bail-out of Northern Rock by the Bank of England probably won’t mean the end of the financial world as we know it. But it could mean the days of cheap credit are well and truly numbered.

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Last Updated: 31 Aug 2010

The mortgage lender admitted this morning that it had been forced to go cap-in-hand to the UK central bank for emergency funding, after cash reserves ran low. With Northern Rock’s full-year profits now likely to be about £100m less than expected, it’s no surprise that its share price sank like a stone this morning.

It’s the first time in years that the Bank has had to delve into its deep pockets to bail out a struggling institution – something that brings out the sweats in investors.

Yet it’s not entirely surprising, given recent events. Building societies used to be fairly simple beasts – prudent savers would put a little bit of money away into their accounts every month, and the building society would use this pile of cash to issue mortgages.

But that was then, and this is now. Compared to other lenders, Northern Rock is much more reliant on the wholesale money markets rather than retail deposits to maintain its cash pool. So when banks stop lending money to each other, as they have done in recent weeks, it was always likely to be the first to run out of cash.

There’s no need for Northern Rock’s customers to panic – thanks to the Bank of England, their £24 billion of deposits are as safe as houses. And the lender itself is likely to survive (albeit perhaps not as an independent). Unlike some of the US groups, it has at least been lending money to people who are going to be able to pay it back. The Bank wouldn’t have bothered bailing it out otherwise.

The case of Northern Rock is a sign of the changing times. With so much cheap debt available, ramping up the mortgage and maxing out the credit cards has been a lot more attractive than building up a nest-egg. People have been saving less, which has meant that the likes of Northern Rock have needed to find cash elsewhere to keep issuing these eye-watering mortgages.

But recent events may have been a timely reminder that this can’t go on forever. With the building societies struggling, borrowing is bound to get more expensive – and who knows, nest-eggs might even start coming back into fashion.

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