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Northern Rock, one of Britain’s biggest mortgage banks, is set to receive emergency funding from the Bank of England today, possibly exceeding £4 billion ($8 billion). The mortgage bank is running low on cash and unable to secure credit on the interbank money market due to ongoing liquidity issues and the substantial risks associated with its subprime mortgage portfolio. Similar to Barclays’ earlier emergency funding, the Bank of England is expected to charge a rate significantly higher than the base rate of 5.75%, possibly around 6.75%.

The stock price has plummeted by 50% since reaching its peak just six months ago, and the current price-to-earnings ratio of 6.75 is expected to increase due to profit warnings and provisions for bad debt, surpassing the recent range of 14 to 17. Technically, the chart appears oversold, but there may be panic among stockholders, which could lead to a new multi-year low in today’s opening as there is a risk of a bank run with savers making panic withdrawals.

The Market Oracle issued a specific warning to investors and savers about the mounting problems faced by Northern Rock as a result of its large subprime mortgage portfolio and the credit crunch caused by the US subprime crisis on August 22, 2007: UK Housing Market Crash of 2007-2008 and Steps to Protect Your Wealth.

Investors: “With a price-to-earnings ratio of just 7.5 and a yield of 4%, the stock may seem enticing, but the markdown anticipates a much higher risk of mortgage defaults and repossessions in the UK as the housing market begins to decline. Repossessions are already affecting companies like Northern Rock, and the rate is expected to triple over the next six months compared to the same period last year. This surge in repossessions will impact the earnings of UK mortgage banks as they increase their provisions for bad debt and issue profit warnings. In Northern Rock’s case, a price-to-earnings ratio of 7.5 could increase significantly in a worst-case scenario.” – Nadeem Walayat, August 22, 2007

Savers: “Invest in fixed interest bonds issued by large, strong banks, and avoid investments from mortgage banks like Northern Rock. Keep in mind that UK savers are protected up to 90% of their first £35,000 of investments in fixed bonds and savings accounts, so it is crucial to stay within this limit.” – Nadeem Walayat, August 22, 2007

Are my Savings Safe?

Absolutely, 100% safe! Well, okay, only the first £2000 is 100% safe under the UK Financial Services Compensation Scheme (FSCS), and the next £33,000 is protected at 90%. Therefore, the maximum safety net is £31,700, covering total deposits of £35,000. It is highly advisable to avoid having savings of more than £35,000 with Northern Rock or any other UK financial institution. Of course, it would be even wiser to avoid mortgage banks with significant exposure to the UK subprime market altogether. However, for the average saver, there is little reason to panic or rush to transfer their £3,000 Cash ISA accounts, unless they find a higher interest rate elsewhere.

Unfortunately, this is just the beginning of the UK subprime housing market collapse. The credit crunch has only just started biting! These current events are just a taste of what’s to come for market participants.

The real impact will come when financial institutions release their quarterly earnings reports, starting in October 2007. Expectations are for at least three quarters of worsening market conditions. The UK property market has peaked, as anticipated, and the credit crunch ensures an extended downward spiral well into mid-2008.

Can the Bank of England Prevent the Inevitable?

Central banks appear to have learned some lessons from the previous liquidity boom. However, appearances can be deceiving! The central banks will likely take a tough stance for several months, providing liquidity at high interest rates to prevent bank defaults. But as economies begin to decline due to mounting bad debts, central banks like the Bank of England will yield to political pressure, especially in the lead-up to elections, by making money much cheaper. This will result in higher inflation, increased commodity prices, and the frequent appearance of the word ‘stagflation’ in headlines a year or so from now.

What else should I do now?

I will not start pointing fingers at specific banks that may go bust during this downward spiral. However, the strategy for protecting yourself is clear and outlined in the previous article, UK Housing Market Crash of 2007-2008 and Steps to Protect Your Wealth.

Additionally, I could suggest paying down debt, reducing household expenses, and diversifying sources of income, although these are easier said than done. This financial problem will not disappear anytime soon, and individuals exposed to the housing market need to make decisions now rather than being forced to later.

Originally Published September 13, 2007

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Ihab Salloum