How safe is your bank?

The model at Northern Rock -- and at Countrywide Financial and its U.S. peers -- is very different. Yes, some of the money lent out in mortgages may come from deposits, but most of the cash comes from the capital markets, where mortgage lenders of every stripe tap buyers of commercial paper for new cash. Mortgages don't sit on the books until they mature, and originating companies actually collect very few monthly payments on these debts. Instead, the mortgages are sold off and then turned into asset-backed securities of various flavors.

Lending faster and faster

This system supercharges the returns that financial institutions can make in the mortgage business. A company that originates a mortgage can sell it off in a matter of weeks, regain its capital (plus a fee for originating the mortgage and, if interest rates and the financial markets break right, a profit on the sale of the mortgage) and then, having freed up its capital, originate another mortgage.

That works just fine as long as the capital markets are willing to lend the mortgage companies the short-term funds that they will turn into long-term mortgages, and as long as the capital markets are willing to buy the securitized mortgages so that the mortgage lender can get the mortgages it has written off its hands and free up its capital again.

This system contains the seeds of its own destruction, however. It encourages lenders to run faster and faster. The more money they can put out in mortgages, the more mortgages they can sell or securitize, the more money they can free up for new mortgages, the more mortgages they can write, and on and on. Growth in deposits can't possibly keep up with this growth in the mortgage portfolio. So leverage at the lending institution grows and grows.

Dependence on capital markets

Northern Rock's loan book is 3.1 times its deposit base, for example. And, because loans are growing far faster than deposits, the bank's reliance on the capital markets increases as well. At the end of 2006, about 73% of the funding for mortgages at Northern Rock came from the capital markets. In the first half of 2007, its dependence had climbed to 85%.

That dependence is intrinsically dangerous because it is based on a mismatch between the lender's short-term liabilities, its borrowings in the commercial-paper market and other short-term markets, and its long-term assets, the 30-year mortgages that back the lender's debt.

The problem with this mismatch is that long-term-debt securities are much more volatile than short-term instruments. So when the market hits a hiccup, the prices of long-term debt, such as mortgages, move down much further and faster than the prices of short-term debt.

For a company that has used the price of long-term mortgages to back its borrowing of short-term paper, that can be a huge problem, as the price of debt backed by long-term mortgages collapses while the company's need for short-term cash continues. With long-term-debt prices falling, the company has less collateral to offer to back the short-term paper it needs to sell to raise capital.

The Bank of England's bailout

In a worst-case scenario, the company can find itself shut out of the short-term-debt market. If the company can't find bank loans to replace the capital from the debt markets, it has to look for a lender of last resort and hope that one of the world's central banks will decide that letting the company go under would do an unacceptably large amount of damage to the financial markets.

That's exactly what happened at Northern Rock. The company found itself cut off from the debt markets. No private buyer, after looking at the likelihood that the company needed an infusion of $15 billion to keep its business going, was willing to step forward. And so the Bank of England extended a line of credit to Northern Rock, and when that didn't calm the financial markets, announced that it would guarantee depositors' savings. (That last isn't small potatoes in a country where deposit insurance covers only $70,000 of a depositor's money.)

Northern Rock is certainly not out of the woods. It's unlikely that the bank will remain independent, and it's not clear who will buy the business that remains without some further government bailout.

Continued: Three red flags

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