domdavis.com

OK, dull and boring post, but this has been annoying me, plus you might learn something about Interest Rates (not much though and it’s all very UK centric).

So, you want a mortgage? Fine, you go to a mortgage lender and they will present you with a number of products, most of which deal with the Bank Of England Base rate. Lets keep this simple and say we get a floating mortgage at 1% over the base rate. So if the Bank Of England say interest rates are 5.75% then our mortgage will be at 6.75%. Easy.

Let us now assume that the company we are getting the mortgage from (lets call them, picking a name at random, Southern Stone) doesn’t actually have the money we are borrowing. Instead they go off and borrow it from another bank. This other bank will charge us interest in this loan at LIBOR (the interbank interest rate in London) which is, usually, going to be less than what we’re charging out customers. If we assume LIBOR is 0.5% above the base rate then we’ll be borrowing money at 6.25%, lending it at 6.75% and making a tidy 0.5% off the life of the loan. Good stuff.

Now let us assume that people have been lending the US equivalent of chavs lots of money at punitive interest rates. Let us further assume that this, frankly quite silly practice, blows up in everyone’s face and causes a little bit of a fracas. We can ignore the majority of what it’s caused and focus on one of the more interesting side effects for us: LIBOR rates get silly. Very silly. Then the banks just stop lending to each other.

Crud, now Southern Stone have no way to get money to lend new money. Hey ho, let’s just go to the Bank Of England and ask them nicely. All we’re doing here is we’re going from commercial banks to the central bank to borrow our money.

Now lets add the media, add a touch of hype, a smattering of frenzy and I can bet you that Southern Stone wont exist in a years time. The few savings accounts they did have were safe. The mortgages they already look after are safe. All that is a problem is raising new money to sell new mortgages to keep the business growing.  If there were any other problems the FSA would have stepped in and the Bank Of England probably wouldn’t be willing to extend the emergency loan facility in the first place (which they haven’t used yet).

So there’s a run on the bank, now the reserves of money are looking tight (thank you The Media), the banks reputation takes a hit (thank you The Media), share price tanks (gotta love equities traders ). Eventually the share price will get low enough that one of the big boys will snap them up strip out the meaty goodness in the form of the existing mortgages and leave the rotting carcass of the company in the bin, but in the mean time it’s all eyes on the poor little company that was just the victim of a blip in the markets and the resulting media histrionics (oh, and a crap capitalisation plan ).

OK, so I’ve grossly oversimplified, but you get the idea. The current run on Northern Rock is purely The Media going “oooh, they’ve got an emergency loan… don’t panic “. If they’d said nothing the great unwashed wouldn’t be queuing to get their money out. Gotta love The Media sometimes.