In the old days, you and I will get together, plonk some money into the cooperative building society as our deposits. Then Mr. X will come to ask for a mortgage and the building society will give him our deposit money. X will repay the money back to the building society at the mortgage rate and the society will give us a savings interest rate which is lower than the mortgage rate obviously. Now, sometimes it would happen that there wouldn't be sufficient deposits coming in from individuals so the society can approach other banks to give some money to the society. The society does not want to turn away borrowers, after all. And in the fullness of time, the lending from the other banks will be covered by other deposits and repayments, and life was good, simple, easy, low risk and fun.
Ok, so the basic problem with Northern Rock was that it was funding its mortgage lending through the wholesale markets rather than mainly through its deposit base. And when the market understood that there was far too much exposure to the wholesale markets compared to the deposit base, the market said, your business is too risky and we cannot lend our depositors money to you as we are not sure you can repay it back. In other words, there was a liquidity problem!
Now this is something that the Financial Services Authority is supposed to track and warn financial institutions if they are going to go off. Well, we know what happened, it all went potty and nobody knows who was responsible for this gruesome mess.
Guess what the FT is reporting now? I quote:
The Financial Services Authority has sent a comprehensive one-off liquidity questionnaire to all banks and building societies asking for details of how they plan to fund future mortgage commitments.
The spreadsheet is designed to pinpoint future problems among mortgage lenders – particularly if the capital markets in effect remain closed for the foreseeable future.
The FSA has asked lenders to give details of their current pipeline of home loans commitments to the end of the year, as well as how much funding they have from the capital markets.It also asks how often the lenders have monitored their liquidity position.
It also wants to know what management actions have been considered as well as what contingency planning is in place. In addition, it also asks lenders what other sources of funding they have.
All very good and nice to know. But very curiously, why NOW? what was it doing before when the credit crisis was in full flow? Or even before when the signals were flashing high and spreads were widening even further than normal?
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