OK, I was thinking about this in the shower this morning. I'm sure the following is a little naive, but I would like to know how reality (tm) differs.
Northern Rock were in the business of handing out loans and then producing mortgage-backs to sell onto the markets, presumably mainly to the creators of CDOs and other financial products. They had side-businesses in taking deposits, and made fees on originating mortgages and handling mortgage payments on behalf of the ultimate onwers of the CDO tranches.
So far so Noughties. Suddenly the market for CDOs and mortgage-backs dried up and Northern Rock's business flew to the four winds. if nobody would buy their product, mortgage-backs, then they couldn't get the cashflow to make new mortgages and produce new product. Thus they run to the BofE for some of that good old-time socialism for bankers.
Now, as the story is told, the BofE is helping them out with a temporary cashflow problem. However, their new business model looks to me like they make loand, then create mortgage-backs and deposit them as collateral with the BofE to get the cash to make more loans and create more mortgage-backs. Thus what they're being loaned by the BofE ticks up by a billion or so per week, and the unpaid interest also piles up at an increasing rate due to the wonders of compound interest.
What began to worry me was that there doesn't seem any obvious end to this. If the BofE says "Enough!" then Northern Rock are back where they started and suddenly can't make any new loans, and will move to windup, only with the taxpayer now on the hook for an absolutely gigantic sum.
The hope that things can get better seems to require the credit markets to "normalise" and demand for mortgage-backs and CDOs to return to business as usual.
However, the major players are now openly saying that SIVs won't survive the credit crunch. Essentially they've been tried and found wanting when the going gets tough, and investment banks aren't going to make that mistake again. What if CDOs, or even mortgage-backs suffer the same fate?
Throughout the credit bubble, which some of us pointed out as early as
1998, we were told that these derivatives portfolios were "stress-tested" and that things couldn't possibly go seriously awry. It seems our skepticism has now trumped their confidence. If CDOs have been stress-tested by reality and found wanting, who's to say they'll make a comeback? They have after all only been around a dozen or so years. They can hardly be regarded as some kind of what Darling called "traditional banking".Worse, this credit cycle, and bubble, has beenn unusual in the sheer numbers of people who were given access to credit. in no previous cycle has there been this mass-availability of credit. In fact the first "mass mortgages", the "artisan mortgages" of London, only appeared at the very end of the previous credit cycle, just in time for it to burst and ruin the players, and the politicians who promoted the first mortgages for the masses.
There's no guarantee that "credit for the masses" will survive the denoument of the bubble. It's certainly not very hard now, reading Roubini et al, to see how the banks could get into a position where they simply can't offer that scale of credit any longer. Then there's what Kindleberger and Mackay called "Revulsion" - a feature of the end of large credit bubbles where investors, stung by what debt can do to them, swear off credit for life and teach their kids to do the same.
If Northern Rock's plan is to borrow a billion a week, and put the interest on tab, until we return to the status quo, what happens if there is no status quo to return to?
FoFP