It was the day the world changed…
Northern Rock seemed like the ultimate business success story.
The bank was founded in 1965 by the merger of two smaller British banks.
In 2000, the FTSE 100 Index added Northern Rock as one of Britain’s 100 biggest companies based on market capitalization.
At the time, it owned 8% of the mortgage business in the country.
But many of its mortgage loans were subprime—meaning they were extremely risky. Those loans were packaged into so-called mortgage-backed securities (MBSs).
By 2007, the $1.8 trillion MBS market was on the verge of collapse. And that sent Northern Rock into a tailspin.
On August 9, 2007, Northern Rock experienced Britain’s first bank run in more than 150 years. Bank shares crashed by 30%.
Northern Rock marked the date as “the day the world changed” for the bank.
A month later, the Bank of England had to step in and throw the company a $32 billion lifeline from British taxpayers. Five months after the bailout, Northern Rock was nationalized.
Northern Rock’s problems caused investors to lose trust in the global MBS market.
A month later, U.S. investment bank Bear Stearns received a $26.3 billion government bailout.
The collapse of Bear Stearns helped trigger the housing crisis in America… and led to the Great Recession of 2008.
Here’s why we’re telling you about Northern Rock…
Another foreign bank is having similar problems. And if it fails, the contagion could spread across U.S. borders just like Northern Rock did back in 2007.
How the Mortgage Fraud Crisis Unfolded
In the past, when banks loaned someone money for a house, they made profits from the interest the homeowner paid on the loan.
Today, that’s no longer the case. The 4% interest banks charge on mortgage loans doesn’t cover the risk of default by the homeowner over the next 15–30 years.
Banks found a way to get around this. They “securitized” loans and sold them to investors as MBSs.
According to a report in The Wall Street Journal, the global market for these securities reached $1.8 trillion at the height of the real estate boom.
Here’s how they work…
Investors pay the lender a fee for originating the loan. The more loans the lender makes, the more it collects in fees. And since the mortgage lender no longer holds the loans, there’s no incentive to make sure the homeowner can pay off the mortgage.
Credit rating agencies gave these securities a prime credit score (AAA), meaning they were low-risk. So there were a lot of takers for MBSs.
This gave lenders a perverse incentive to cheat on mortgage applications. They got paid to make the loan… not on the collection. Investors unknowingly took on all the risk.
Northern Rock was an aggressive seller of these subprime mortgages.
Eventually, investors caught on and started selling Northern Rock loans. That triggered a sell-off in the entire MBS market and plunged the banking sector into a crisis.
Today, we’re seeing a similar scenario unfold. This time with one of Canada’s biggest subprime lenders.
The Tip of the Iceberg
According to the Canada Housing Trust, there are $169 billion in outstanding MBSs in that country.
Home Capital Group (HCG.TO) is one of largest lenders of these securities in Canada. Like Northern Rock, HCG is an aggressive seller of subprime loans. And like Northern Rock, it’s now facing bankruptcy.
On April 26, the company’s stock fell 65%. So far this year, HCG is down over 83%.
To stem a bank run, HCG had to take out a $2 billion emergency loan. The bank’s credit rating was downgraded twice in one week on the news.
HCG’s looming collapse might not appear to be a big deal to Americans. But you’d be wrong to think that.
U.S. funds hold almost 20% of the MBS market in Canada.
If the Canadian market tanks, the contagion could spread to U.S. financial institutions… just like Northern Rock did in 2008.
That would set us up for the Great Recession 2.0.
We’ll watch this situation closely.
Meanwhile, avoid Canadian mortgage lenders, homebuilders, and developers. And we’ll let you know if the contagion spreads to any U.S. companies.
Nick Rokke, CFA
Analyst, The Palm Beach Daily
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