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The Ridley Riddle Part Three: Like a Northern Rock

Posted on 12 August 2011 by Andy Skuce

This is the third and final article in the series on climate contrarian Matt Ridley. Here are Parts One and Two. 

This article will look at Matt Ridley’s involvement in the collapse of the British bank, Northern Rock, in 2007. I am not the first to attempt to link this business disaster with with his views on climate change; George Monbiot wrote an articleThe Man Who Wants to Northern Rock the Planet, remarking, among other things, on the contradiction between Ridley’s small-government libertarianism and his begging the Treasury for a bail out of his company.

The rise and fall of Northern Rock

Matt Ridley was the non-executive Chairman of Northern Rock, a British bank that, in 2007, was the first in over a century and a half to experience a run on its deposits. British banks had all survived two World Wars, the Great Depression, and the end of the British Empire, until Northern Rock failed. Ridley had served on the Northern Rock board of directors since 1994 and was appointed Chairman in 2004. A previous Chairman of the bank was his father, Viscount Matthew Ridley.

Northern Rock’s depositors responding rationally but not optimistically to market signals. Source

Northern Rock’s business model was a very aggressive one, centered on rapid growth of its mortgage business. Before 1997, Northern Rock was a building society, a co-operative savings and mortgage institution. Like many other British building societies, it transformed itself into a bank and was listed on the stock exchange. This led to rapid growth for Northern Rock, which grew its assets at an annual rate of more than 23% from 1998 to 2007. Before its crisis, Northern Rock had assets of about $200 billion and was the fifth-largest bank in Britain.  The bank’s retail deposits did not grow at the same rate as its mortgage assets; the difference was made up with funding from capital markets. When the credit crisis hit in 2007, Northern Rock saw its funding vanish. Northern Rock’s debts were more than fifty times its shareholder common equity, making the bank an outlier even among the many other highly-levered financial institutions at that time. This made the bank particularly vulnerable to changes in the credit markets. The bank was unable to pay its creditors and had to turn to the Bank of England for help in September 2007. These events led to panic among its depositors, who formed huge queues outside its branches to withdraw their savings.

No one saw it coming?

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame himJohn Maynard Keynes, 1931.

One month after the bailout of Northern Rock, there was an inquiry by a UK Parliamentary committee at which the senior Northern Rock managers were subjected to a grilling. The entire minutes of the session are interesting to read; here’s a short excerpt:

Q404  Mr Fallon [Treasury Committee, Conservative Member of Parliament]: But a heavily leveraged bet on the movement of interest rates and on capital markets remaining open for an over-exposed model like this seems to me a fairly basic banking error, is it not?

Dr Ridley: We were subject to a completely unpredicted and unpredictable closing of the world credit markets. Our model was entirely transparent to the market and to the regulator. It was discussed regularly with both and it was not at the time seen as running a particularly high risk in terms of liquidity.

Q405  Mr Fallon: But it was your duty as Chairman and as a Board to ensure that your bank was liquid.

Dr Ridley: We reviewed liquidity regularly and we reviewed our policy on liquidity and our policy on funding regularly.

Q406  Mr Fallon: But you were wrong?

Dr Ridley: We were hit by an unexpected and unpredictable concatenation of events.

Q407  Mr Fallon: So you are the Chairman of a bank that ran out of money and that caused the first bank run in this country for 150 years; you have had to borrow billions of pounds of public money from the Bank of England; you have damaged the good name of British banking; why are you still clinging to office?

Yet, the events leading to the credit crunch, the bursting of the housing bubble and the collapse of financial markets, were not entirely unforeseen, especially by commentators outside the banking sector. Table 1 in this article, for example, lists eleven separate warnings from academics and analysts. In 2006, Robert Shiller of Yale University wrote: "there is significant risk of a very bad period, with slow sales, slim commissions, falling prices, rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected.” The specific case of Northern Rock’s exposure was clear to at least one financier, Australian John Hempton, who, in 2005, wrote:

If you grow risk by 25 per cent and profits and capital by 15 then either you will run out of capital and the regulators or rating agencies or bond markets will not allow you to fund your growth – in which case the growth fizzles out at best, or you will eventually be taking so much risk that the return on capital will not be rational in an ex-ante basis. Some point ex post you will blow up, possibly spectacularly.

Crucially, the credit markets knew very well that Northern Rock was an exposed outlier, which led to the company being the first among all the British banks to fall.

 

According to Shin (2009), the common equity leverage of US investment banks in mid-2007 was in the range 25-30. The final uptick of the hockey stick graph after June 2007 was caused by the share price collapse in the Fall of 2007.

Perhaps any warnings of a housing bubble were dismissed in the boardroom as model-based speculation; perhaps cautions about unsustainable growth were said to be unduly alarmist; perhaps even hockey-stick graphs showing Northern Rock’s growing leverage were scoffed at as being statistical artifacts; anybody silly enough to speculate that liquidity risks could lead to a bank run would have been laughed out of the boardroom. However, as events unfolded, Northern Rock’s shareholders, creditors, customers, and the British taxpayer would surely have concluded that their interests would have been better protected had there been a few rational pessimists on the Northern Rock board of directors.

Motes and beams

Matt Ridley has been highly critical of the IPCC reports and of the Chairman of the IPCC, Rajendra Pachauri, mainly for the overblown stories about the Himalayan glacier typo and the poorly-referenced but correct accounts of the Amazon Basin’s vulnerability to drought. Yet for all the accusations that the IPCC has exaggerated impacts of climate change and  “sexed-up” summaries for policy makers, its track record is solid compared to the rosy business outlook that Ridley portrayed in the Northern Rock Annual Report 2006, and published in early 2007, just a few months before the company failed.

Two senior officers of Northern Rock—the Deputy Chief Executive and the Managing Credit Director—were heavily fined in April 2010 by the UK Financial Services Authority for hiding the decline in the performance of the company’s mortgage assets in early 2007. There’s no suggestion that Ridley played any role, or, at the time, was even aware of this misrepresentation of important financial data. All the same, the transgressions happened under his watch as Chairman and, as far as I know, he has not since expressed any regret for the incident.  Nevertheless, a few months after his former colleagues had been sanctioned, Ridley had the audacity to write an article for the Times in which he referred to the “discredited Dr Pachauri” in “shut-eyed denial”. Yet none of the contributors to Chairman Pachauri’s reports has ever been shown to have deliberately misrepresented any data.

Comes before a fall

When you view Ridley’s TED talk When Ideas Have Sex, there’s no doubt that he is a passionate communicator of the idea that David Ricardo’s theory of comparative advantage was a major driver of human cultural development over the past 100,000 years. And when you read the Chairman’s Statement for the 2006 Northern Rock Annual Report, he expresses genuine pride in reporting not only the financial results of the company, but also the company’s generous support of the charitable Northern Rock Foundation. Matt Ridley is not greedy, he is an idealist. When you read The Rational Optimist, it’s clear that he’s not at all indifferent to the future, but the ideological lens through which he views the world distorts and obscures some things as much as it brings others into focus. In the Introduction to The Rational Optimist, Ridley writes a paragraph about Northern Rock, which concludes:

But what made the bubble of the 2000s so much worse than most was government housing and monetary policy, especially in the United States, which sluiced artificially cheap money towards bad risks as a matter of policy and thus also towards the middlemen of the capital markets. The crisis has at least as much political as economic causation, which is why I also mistrust too much government.

Even though Northern Rock freely chose to gather up, with both hands, all of the cheap money from the middle men of the capital markets that it could, for as long as it could and to a greater extent than its competitors did, for Ridley, the lesson of the crisis is that it was the government's fault. Even after the business disaster that he presided over, Matt Ridley’s avowed Rational Optimism has not been tempered by the experience. He asserts, contrary to the facts, that the "concatenation of events" that hit Northern Rock was "unexpected and unpredictable", while having the hubris to claim, based on his prejudiced assessment of the science, that:

Over the past few years it has gradually become clear to me that climate change is a nosebleed, not a severed limb, and that the remedies we are subsidising are tourniquets round the neck of the economy.

From the Northern Rock 2006 annual report.

For Ridley, in business as in climate, prudent precautionary measures are rejected as ruinous, whereas warnings that real disasters may be lurking are dismissed. As the Northern Rock experience showed, being dazzled by the power of virtuous circles can blind you to the fact that, if spun too hard, they can quickly turn vicious.

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Comments

Comments 1 to 12:

  1. Thanks for another enjoyable read. It is interesting to see so plainly that in quite a lot of cases, ideology is the main reason for dismissing climate science. Debunking such people is a thankless task, but one which will hopefully help in the long run.
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  2. Andy, Iloved your use of "hockey stick", "alarmist" and "hide the decline". So very, very apt.
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  3. I also recommend readers click on the link to George Monbiot's article, which provides a rather devastating take-down of some of Dr. Ridley's other baseless claims.
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  4. As the collapse of the bank shows, the assets that were growing could scarcely be said to be high quality.
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  5. This has been a great series to read and covers pretty much what I've been thinking after reading Rational Optimist and Ridley's blog. It is a shame for me as I, like many others, have enjoyed his other books. I saw his 'When ideas have sex' talk at the Life Centre in Newcastle, but people were mostly wondering whether he would mention Northern Rock or not.

    Excellent series though.
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  6. Northern Rock was a relatively innocent victim of the general banking crisis.
    This can be shown by the decision of the Government to split the Nationalised Bank into two parts.

    1. A good bank
    2. A bad bank

    The bad bank contained virtually all the mortgages and bond commitments.
    Two years ago most people thought that this part would lose money and could not be sold.
    Recently however the "bad bank" has been making a profit while the good bank is still making loses.

    Northern Rocks model was to borrow against its existing mortgages.
    But when the AAA rated American Mortgage Obligation Bonds was shown to be worthless nobody would lend against mortgage backed credit.
    Several of the major banks were technically insolvent because they held large quantities of these by now worthless bonds.

    One choice fact for those who believe in conspiracies.
    The British Government was paying for advice from Goldman Sachs about what to do with Northern Rock.
    Meanwhile Goldman Sachs had a massive hedge fund which was betting an a housing bond crash.
    Goldman Sachs have been forced to pay compensation to other Banks because of this chicanery.
    Northern Rocks mortgage book was always relatively clean as is now proved by the "bad" bank making a profit.
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  7. I have engaged a few times in debates with far-right near-anarchist ideologists, and basically they come down to these disclaimers:

    1) whatever the market does, it is the best realistically possible outcome.

    2) If something bad comes out of it, it's because people chose that outcome, and therefore they deserve it. (the Tragedy of the Commons is a "choice" here. Fishermen "choose" to deplete the resource they depend on)

    3) whatever the government does, it will only worsen item 1). If the same action was done by a non-regulated private agent, then it's again the best possible outcome.

    4) if a government existed around any bad outcome, it's a prime escape goat to explain it.

    I love the free market. I depend on it to live. But diffuse externalities are not well delt by uncoordinated agents. That's a limitation its fans refuse to see. At the end of the day, it looks more like blame-shifting than helpful ideological guidelines.
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  8. Alexandre, you might add to that:

    5) Responsibility is limited by knowledge. If one has no foreknowledge of an outcome of one's actions, then one is not ethically/morally responsible for the outcome. Morality, then, becomes an exercise in tightly controlling the knowledge one accepts. Doubt becomes a highly desirable commodity. People are willing to pay for it, yet its utility only serves the bottom line; it is not understood as true skeptical doubt, the servant of progress.
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  9. suibhne at 02:02 AM on 13 August, 2011
    "Northern Rock was a relatively innocent victim of the general banking crisis."

    Not true. When you are leveraged 30 to 1, a 4% decline in assets puts you in bankrupcy. What market doesn't decline from time to time?

    Excessive leverage is what got the U.S. banks and brokers too.
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  10. bibasir

    "Not true. When you are leveraged 30 to 1, a 4% decline in assets puts you in bankrupcy. What market doesn't decline from time to time?"

    The thing that doomed Northern Rock was to assume that the rest of the market was regulated properly.
    Their main assumptions were
    1. Do not lend more than the house is worth or the borrower can pay.
    This policy has turned out to be vindicated by the Bad Bank continuing to make a profit.
    2. If NR has a relatively clean mortgage book then pension funds and others who require a steady income will buy their scrutinised bonds.
    3. That there will be a sufficiently liquid money market.

    It was point 3 that sunk the Rock.
    As explained above and subject to criminal investigations the hedge fund controlled by Goldman Sacks was given control over their mortgage arm.
    The hedge fund placed futures on a house market crash and went out of their way to make sure it happened.
    American AAA rated mortgage backed bonds were found to be worthless.
    Nobody was quite sure who held exposure to such junk the money market froze.
    HSBC refused overnight clearance of Barclay's credit(unprecedented)
    The rest is history.
    The problem that caused Nationalisation was that two other Hedge funds has virtual control over NR shares and would not sell to Virgin for a price rumoured to be 20p per share.
    As the chancellor Alistair Darling said on the say of Nationalisation.
    Northern Rocks assets were greater than its liabilities.
    Hence it was never in danger of being bankrupt.
    It had a major problem of liquidity due to market conditions
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  11. suibhne I am not convinced.

    The reason I am not convinced is that mortgages are a fairly safe bet as long as you take a little care on who you lend to. This means the limiting factor on the number of mortgages you can lend is how much capital you have available.
    Its clear that this was not the case for Northern Rock, they had to keep burrowing money for the capital they required. Many a say a good rule of thumb is that a bank should not ever have a leverage ratio of more than 10 - if you do not want a banking collapse.
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  12. Mighty Drunken

    ....."ever have a leverage ratio of more than 10 - if you do not want a banking collapse."....

    Capitalism has proved itself incapable of escaping the boom then bust cycle.

    That's the system.

    However to isolate the real villains in this particular cycle is important.
    Goldman Sachs is at one extreme and Northern Rock at the other.
    Goldman Sachs executives and related hedge fund should be in jail and perhaps will.
    Northern Rock were naive and thought they could always go to the market for money against their portfolio.

    If Northern Rock was a private bank whose shares could not be shorted they could have survived the downturn.
    Mortgages it may surprise you to know have an average life of less than 3 years.
    Northern Rock could have stopped lending shut most branches paid off the bulk of the staff and use the expired mortgage returns of capital to redeem bonds.

    This is essentially what the "bad bank model" is.
    The "bad bank" makes a profit.

    The only long term solution is the world socialist revolution.
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