Death on the Rock

(not Charlton related)

Northern Rock tonight confirmed it had been forced to ask the Bank of England to act as its 'lender of last resort'. As shirt sponsors of Newcastle United, it seems sad that the news comes just 24 hours after their striker was England's darling at Wembley. It is appropriate however that his surname is 'Owen'.

Just to reassure anyone who may have their life savings at Northern Rock, the Bank of England website confirms their role as 'lender of last resort' is "...expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy’" So that's ok then.

As someone who's been bearish on UK property for most of this century, I'm entitled to enjoy those (very) occasional days when some degree of vindication appears in sight. It takes rare guts after all to continue to think you're early rather than just wrong, whilst true to the spirit of John Maynard Keynes, always steadfastly checking that the facts haven't changed.

A friend of mine's wife has even banned him from discussing the market with me for fear, shock horror, that she will be forced to vacate her much-loved home for a (nicer) rented place (for less money). But then again, given that I also sense that next Monday will bring a housing stat probably shocking enough to knock Madeleine off the front page of the Daily Express (surely not - Ed.), so perhaps the ban will soon be lifted.

But before anyone quits reading this blog in disgust at my lack of sympathy for the overleveraged UK homeowner, it is worth repeating three points that will be familiar to anyone that has had the misfortune to go for more than two pints with me. Firstly, house price rises don't make a country richer (it just redistributes the wealth), and second they only benefit those planning either to quit the market at a profit, who then plan to rent, downsize or preferably leave the country altogether; I get the firm impression from reading comments in the UK media that the middle classes have finally cottoned onto this anomaly. Finally, any reasonable basket of global equities has vastly outperformed UK property in the past five years; any perceived difference is of course due to leverage (which can be a two-headed beast).

Without wishing to get too technical, I suspect a disturbing number of UK homeowners have become complacent about rising prices, and are thus insufficiently diversified if the tide does indeed turn this time. Many UK families essentially own a single asset, and are simultaneously long a call option on it (they participate on a leveraged basis in its upside), but are also short a put option on it (the lender can force them to make good on the full value of the loan against it). The renter has neither, but pays less for the right to live there (thus the net value of the two options must be equal to the difference in cost between renting and buying). Until now, the call option has been massively 'in-the-money' and the put option worthless; this may be about to change.

Rising real incomes (via productivity gains) drive increases in wealth; anything else is a chimera. The UK's housing stock is sheltering us just as well as it did five years ago; its 'value' hasn't increased any more than the incomes we have generated to rent it, only banks increased willingness to lend against it has increased (now clearly to be tested). And with rental yields well below the cost of finance (destroying the argument that "..rent is money down the drain"), and the market environment increasingly uncertain, it will be interesting to see if the only marginal buyer left (the buy-to-let landlord), is willing (and more importantly able) to maintain his position. It is worth recalling that Northern Rock has provided fully a fifth of new UK mortgages in 2007, many of them buy-to-let.

As for the housing shortage argument, trotted out with such regularity as if it were not even challengeable, it cannot explain the gentle rise in rents over the same period (surely the supply/demand argument affects these too), or the discernible lack of homeless people clogging all of our towns and cities. Also it seems to be an argument used to explain away London and the South East's strong rises, yet other less palatable regions like Northern Ireland have risen even faster.

The housing shortage argument also struggles with the severe 1990s housing corrections suffered in Tokyo and Hong Kong, two places not exactly well known for their wide open spaces. (By the way, if you want to know what a true housing shortage looks like, check out Fort McMurray, the hub for the booming Canadian oil sands industry.)

After several years of being early (wrong - Ed.), it would be premature to call the top of the market on the back of one RICS survey, and the virtual insolvency of a high-profile lender. But it would be equally disingenuous to believe the UK economy is somehow immune from the global credit crunch which shows no sign of abating, and has popped similar bubbles in Ireland, Spain and of course, the US. And lest anyone had forgotten, the 'inflation problem' has not gone away, reducing the wriggle room of the Bank of England to cut rates to avert a potential recession.

It is tempting to blame the current turmoil on the US subprime mortgage market, but in truth the first evidence of the credit madness could just as easily have cropped up elsewhere. It's known in finance as cockroach theory; if you find one cockroach, you will be sure to find more. Subprime mortgages were the first cockroach.

The state of the financial markets today is an exact mirror image of that observed until just a few weeks ago. Until then, the banks were involved in a global struggle to lend at less exacting terms, desperate to maintain their position in the hierarchy, sure in the knowledge that a less risk-averse competitor would fill the breach. The fact that approx $300bn of 'leveraged loans' (used to fund leveraged buyouts) are in effect stuck on the balance sheets of major banks (with little if any pushback to the original buyer), is testimony to the degree of the madness. As today's renter may one day find out, those with dry powder (ie. cash) are seeing incredible opportunities to pick up distressed assets.

Now, with markets panicking about unknown exposures to 'toxic' assets, evidenced by extraordinary moves in short-term interest rates, the opportunity cost that keeps bankers awake at night is the one of doing business, as opposed to not doing business.

Northern Rock's risky business model (which did not emphasise a strong deposit base), rewarded its shareholders handsomely during 'normal periods', but now we are in the realm of the unknown. As my favourite author Nassim Taleb describes it in his book, "Black Swan", the frequency of unexpected events is almost always underestimated, yet humans are wired to find ways to convince themselves they were explainable with hindsight. If it wasn't for those pesky US subprime borrowers....If only the Bank of England hadn't raised rates....

As a result, the system is clogged up and the central banks are loathed to clear it out (even to the extent they are able to), for fear of creating a 'moral hazard', and thus an even bigger problem next time around. And thus in a sudden change of fortune for the poor neglected saver, it's a rare chance for him or her to have their day in the sun. 7.05% for cash in the bank? You'd be daft not to (so long as it's not Northern Rock).