What triggered this crisis?
Northern Rock, a Newcastle based mortgage lender, has been hit by the “credit crunch” affecting financial institutions since early August.
The roots of this crunch lie in the US “subprime” mortgage market, which involves lending to borrowers with poor credit ratings or low incomes.
Many people are now defaulting on these subprime mortgages, which has triggered panic across world markets.
Subprime lenders used complex financial techniques to repackage and sell on their debts across the world’s markets.
This means nobody really knows which financial institutions are holding the bad debts, or how large the bills will eventually be.
The panic is made worse by the high levels of debt that have financed consumption, speculation and investment in recent years.
Faced with this situation, financial institutions have suddenly become very wary of lending money to one another – leading to today’s credit crunch.
Why was Northern Rock hit so badly by the crunch?
Northern Rock has been, as the Financial Times put it, “one of the most enthusiastic users of the capital markets to finance its mortgage lending business”.
It was not the first to be hit. On Monday of last week, a little known firm called Victoria Mortgages was forced into administration.
Victoria Mortgages was a small company which specialised in the British version of subprime lending.
Rather than holding savings, it simply borrowed money from large financial institutions and lent it to borrowers with poor credit histories – cashing in on extraordinary levels of consumer debt and Britain’s housing bubble.
Northern Rock is a much bigger player. It is Britain’s fifth largest mortgage lender with 1.4 million savers and 800,000 mortgage customers.
In 2006 Northern Rock made profits of £627 million and lent £33 billion, an 8.3 percent share of Britain’s mortgage market.
The company was hit last week because it has relied more than its rivals on borrowing to fund its business.
This is what has allowed Northern Rock to expand rapidly and aggressively, turning from a small regional building society to a major player in mortgage lending within the space of ten years.
It has lent three times as much as it holds in savings and deposits. The next highest ratio of loans to savings and deposits, that of Bradford & Bingley, is two to one.
Northern Rock offered mortgages at 125 percent of a house’s value and at five times the borrower’s income.
It even moved into the subprime market in partnership with the US banking giant Lehman Brothers, which is now heavily implicated in the US subprime crisis.
But Northern Rock’s business model – borrowing money in short term loans to lend it over the long term – simply did not consider the possibility of a credit crunch.
What will happen to Northern Rock next?
The Bank of England, in its role as “lender of last resort”, stepped in to bail out Northern Rock – the first such rescue since the mid-1970s.
The Bank of England and the chancellor Alistair Darling feared the collapse of Northern Rock might bring down the whole financial system.
When news of the rescue got out, Northern Rock’s shares plummeted and savers queued to withdraw their cash.
It is possible that Northern Rock, either as a single company or broken up into several parts, will now be bought up by its rivals.
But if other companies are unwilling to take it on, Northern Rock may simply be run down.
Either scenario will terrify the 6,500 staff at the bank, mostly in the north east of England, who now face an uncertain future.
Are the problems likely to spread further?
Other lenders have already raised their interest rates on their mortgages.
For instance Halifax, Britain’s biggest mortgage lender, raised the price of many of its new “tracker” mortgages last week.
Lenders such as Halifax say the difficulty they face borrowing money has forced them to increase mortgage rates.
This will cause problems for the millions of ordinary people who already struggle to make mortgage payments – especially as they can no longer necessarily rely on the value of their house rising steeply.
The problems are not just in the financial sector. The crisis could easily spill over into other sections of the economy.
This is especially true if the US economy heads into recession – a possibility that has been raised by some mainstream commentators.
Underlying the crisis is a spiralling level of debt in recent years. Total consumer debt in Britain hit £1.3 trillion in July this year.
Average household debt is now greater than £50,000. The government itself is in debt, as are many companies.
A lot of this borrowing is simply to fund speculation – gambling on Wall Street or in the City of London.
But some of it is essential to the “real” economy where goods and services are produced. This will now become much more difficult.
And for capitalists, consumer debt is essential. They want to pay workers as little as possible, in order to maintain their profits, but they want workers to buy as much as possible.
If workers take on debts and “live beyond their means” the capitalists can achieve this goal – for a time.
The collapse of Northern Rock is a symptom of a much bigger sickness, and we are likely to see many more symptoms in the weeks ahead.
All the instincts of Gordon Brown and Alistair Darling will be to protect the City fat cats and make ordinary workers pay the price.