Financial Situation of Northen Rock Compared to HBOS

The topic I have chosen for my Research Analysis Project is “Analysis of Financial Situation of NORTHEN ROCK plc with comparison to HBOS plc” for the year Ended 2006, 2005 & 2004.

1.2 CONTEXT

Global Economy is indicating that we are moving towards recession, which affected the customer confidence and buying power. Even though the Bank of England Base Rate has been rising, it remains relatively low by historic standards. Long term unemployment remains low and we continue to see stable levels of economic growth.

1.2.1 We expect house price inflation to moderate, and we continue to see little prospect of a severe house price correction, given that mortgages remain comparatively affordable. High street banks & financial institutions used heavy marking strategies to gain the customers confidence.

Northern Rock is currently the 5th largest UK mortgage lender, and the largest financial institution based in the North East of England. Northern Rock ran into liquidity issues in late 2007, (http://www.lse.co.uk)

1.2.3 Northern Rock Building Society was formed on 1 July 1965 as a result of the merger of Northern Counties Permanent Building Society (established in 1850) and Rock Building Society (established in 1865). Northern Rock Building Society then merged with a number of small local building societies and, prior to its conversion to a public limited company in October 1997, was an amalgamation of 53 societies.

1.2.4 A significant development in the recent history of Northern Rock was its conversion on 1 October 1997 from a building society to a public limited company, listed on the London Stock Exchange and authorised under the Banking Act 1987. The conversion also resulted in the establishment of The Northern Rock Foundation, a charitable body which is entitled to receive approximately 5% of the annual consolidated profit before tax of Northern Rock plc.

MORTGAGE & FINANCIAL INSTITUION SECTOR

1.2.5 A mortgage is a method of using property (real or personal) as security for the performance of an obligation, usually the payment of a debt. The term mortgage refers to the legal device used for this purpose, but it is also commonly used to refer to the debt secured by the mortgage, the mortgage loan. (http://en.wikipedia.org/wiki/Leverage_(Mortgage))

Financial institution

1.2.6 Northern Rock is a financial institution, in economic terms; a financial institution acts as an agent that provides financial services for its clients or members. Financial institutions generally fall under financial regulation from a government authority. Common types of financial institutions include banks, building societies, credit unions, stock brokerages, asset management firms, and similar businesses. (http://en.wikipedia.org/wiki/Financial_institution)

Function

1.2.7 Northern Rock’s function as a financial institutions provide a service as intermediaries of the capital and debt markets. They are responsible for transferring funds from investors to companies, in need of those funds. The presences of financial institutions facilitate the flow of monies through the economy. To do so, savings accounts are pooled to mitigate the risk brought by individual account holders in order to provide funds for loans. Such is the primary means for depository institutions to develop revenue. Should the yield curve become inverse, firms in this arena will offer additional fee-generating services including securities underwriting, sales & trading, and prime brokerage. (http://en.wikipedia.org/wiki/Leverage)

2.0 Aims & Objective

2.1 REASON FOR CHOOSING THIS TOPIC

2.1.1 The fifth Largest UK lender Northern Rock was ejected from the FTSE 100 and narrowly escaped the small companies cap and fell to FTSE 250, after seeing its share price dive by more than 85% to just 103p following revelations that it had agreed emergency funding with the Bank of England. But the group should avoid the ignominy. (http://www.nebusiness.co.uk/business-news)

2.1.2 Northern Rock and HBOS plc both are mortgage lenders with their base almost in international market but the reason to why the credit crisis in USA affected Northern Rock plc. (Northern Rock Share price, www.lse.co.uk)

2.1.3 With more lenders in the market, competition for new customers rocketed. Instead of staying loyal to your mortgage lender for 25 years, you were expected – and encouraged – to switch every few years. Just one in five mortgage borrowers are now languishing on their lender’s SVR (which is usually 2% higher than the most competitive two-year deal), with the vast majority re mortgaging periodically to a new deal with a new lender. And the result of all this competition was that UK mortgage market became one of the most competitive in the world. (http://www.ftse.com)

2.2 AIMS and Objectives of the Report

2.2.1 To analyse the fragile nature of the international capital market and how perilous it can be.

2.2.2 The purpose of this project is to analyse the financial performance and position of Northern Rock which in terms would also explain certain factors of high street lender and financial institutions. The lenders need to satisfy the FSA regulations for liquidity. Its ability to fulfil its liabilities is measured by financial position of a Company.

2.2.3 To analyse the change in financial stability of Northern Rock and ascertains its relevance to current situation of the company.

2.2.4 The commentary on the ratios would be of little use without comparison to its surrounding market in which it’s trading in. The pragmatic evidence suggests that industry classification is the primary factor in explaining ratio dispersion and ratio of individual firms tends to converge towards the industry wide average.

2.2.5 Ratios analysis is rationalised when relating them to current changes in the industry. The company’s annual reports over the years 2004-2006 have been used to carry out the ratio analysis, which provides the basis for any conclusions made thereof. Also, competitor’s report (HBOS, Abbey) have been used to draw various comparisons between their business operations and those of Northern Rock’s.

2.3 INFORMATION GATHERING

Sources Used and Reason for their Use

The main source of information for the topic is the Annual reports of Northern Rock which constitute the financial statements for 2003, 2004, 2005 & 2006 audited by Pricewaterhouse Coopers.

2.3.2 Most of the analysis is based on ratios; relating them to current changes in the industry has helped in rationalising the numbers.

2.3.3 Various internet articles and reports by Market analyst have provided a firm basis for the analysis of the overall Lending Sector and financial institutions. The internet is also very helpful tool for me to extract the information on any event related to Northern Rock, the reference of the web sites are mention at the Bibliography section of thesis.

2.3.4 Northern Rocks official Website also contributed a lot towards my analysis and I had directly spoken to an official of Finance & Accounts Department at the Head office of Northern Rock. The details for most of the material are located at this site:

http://www.northernrock.co.uk/

3.0 ANALYSIS

3.1 Corporate valuation

3.1.0 In order to evaluate how significant a financial Institution’s balance sheet is in comparison to non-financial firm, it is important to consider how an industrials firm wields capital machinery (asset) and the loans (liabilities) it used to finance that asset. The line is blurred in Financial Institutions, which must hold deposit accounts with bank and with customers. Northern rock’s Liability of deposit account fell in 2004 by 17.78%, but displayed in the graph, it jump to 39% in 2006. It needs to hold the deposit account to fuel the issuance of loans to bank/customers which was 6.49% in 2004 and then substantial increase in 2005 to 38.9% but in 2006 the issuance of loan to bank increase with slow curve of 10.79%. The same accounts are considered loans as they are held in ownership not of the bank, but of the individual client.

3.1.2 The Northern rock results for lending were modestly above expectation with excellent earning growth. NRK is the bank with the greatest exposure to the UK mortgage market, which has been robust so far in 2004. Lending in 2004 was £2,0051m and increase of 31.80% from 2003 and because NRK thought that the mortgage market will remain vigorous despite rising interest rates. In 2005 increase of Residential lending was 17.79% which jumped to 22.67% in 2006, the interim results of 2007 shows that NRK continued to achieved record lending of £19,328m an increase of 30%, on other hand HBOS Retail (residential) Lending was up by 21% in 2006 and in same year its Mortgage lending was up by 8.90%

3.2 Capital Structure/ Investors Ratio

3.2.1 Major portion of banks assets consist of residential mortgages (77%). 13% of its assets is kept in money market instruments or overnight deposits, which are considered as liquid assets due to ease of conversion in to cash. Banks need to maintain current assets to fulfil capital adequacy requirements by the FSA and other regulatory agencies.

3.2.2 The Residential lending was 87.82% in 2006 which shows it is a highly geared company as its funding itself from the customers and in the whole sale market its liquid asset was just 13% in 2006 which indicate high risk profile. As the asset growth in 2006 for NRK was only 22.10%. In comparison to HBOS, whose Residential lending was 43%, which was lower then its previous year of 47% to control the gearing and maintaining low risk profile of company.

3.2.3 In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified.

3.2.4 In 2006 the Capital leverage ratio of Northern rock dropped from 14%(2004) to 11.60%, it sheds almost 2.6% over 2 year, where as HBOS put a very good control as its Capital leverage ratio was at 12% in 2006, a 0.02% increase from 2004 when at was at 11.80%.

3.2.5 Corporate leverage decisions are among most difficult decisions made by finance executive. This is because excessive usage of leverage can lead to financial distress and bankruptcy. On the other hand, insufficient usage of leverage is also undesirable because interest paid to borrowers is tax deductible; hence using too little debt results in under utilisation of valuable tax shields. (Sudipto Sarkar(2003), Economic Journal)

3.2.6 The Capital leverage on its own is of little help without the consideration of Tier 1 Ratio.

3.2.7 Northern Rock has to maintain its Tier 1 ratio to comply with FSA regulations to limit its lending. In 2006 Tier 1 Ratio of Northern Rock plc was 8.5% which was improved from previous year 7.7 %( 2005), overall it was drop of 0.02% from the Tier 1 ratio of 2004 8.70%

3.2.8 Tier 1 notes were issued for a value of £200m on 21 August 2002 and are undated. They carry a coupon of 7.053% payable annually in arrears on 21st September each year. Northern Rock has call option which it could exercise after 25 yeas with the consent of FSA.

3.2.9 The lenders are highly geared due to nature of their business, In 2006 gearing for Northern Rock was 19.94 which constantly increased from 2005 17.79 times to 2004’s gearing of 14.13 times. HBOS maintain it’s gearing below 30 for last three years; it was 26.92, 28.31, 27.76 from 2006 to 2005 & 2004 respectively.

3.2.11 The portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share are generally considered to be the single most important variable in determining a share’s price. Northern Rock EPS was jumped to 12.46% in 2004 but drop up to 3.20% in 2005. The Management effectiveness was strongly emerged in 2006 when EPS rides up to 30.48%.

3.2.12 The Price Earning Ratio (P/E) is referred to stock market ratio, commonly described as an earning multiple. The higher P/E ratio, the faster the growth the market is expecting in company’s future EPS. At the end of 2006 the NRK has a shocking P/E ratio of 0.88 because of its fall in current share price which was trading at 90.00p, just 51 weeks before in Jan 2006 its share price was trading at 1,178p and has a P/E of 16.25%. Whilst HBOS, in comparison, has its P/E in 2006 at 7.31%.

3.2.13 The Dividend cover is a policy often designed to satisfy shareholders. It’s a relationship between the available profit and dividend payout. In 2006 NRK plc has dividend cover of 2.90 times it has been fallen from last year when it was 3.04 because of the profit distortion and huge growth in operating expense in 2006 amount to 11.26%. Whilst HBOS dividend cover was almost stable at 2.4 times in 2006.

3.2.14 The Total dividend paid out was raised by 20.3% to 36.2p compared with 13.6% increase last year to 30.1p. It was also not a bad year for HBOS as it also enjoyed an increase of 15% to 41.4p dividend paid out for 2006.

3.2.15 Return on Equity (ROE) is a common financial ratio used by investors to assess how effectively a company employs capital invested in it by shareholders. We saw a continuous growth of 21.90% in 2004 to 23.50% in 2006.This shows management has continued to efficiently return money on shareholder capital.

3.2.16 One trait of ROE is that the percentage return equals the maximum amount a company can grow without taking on additional financial leverage (i.e. debt). While debt is not necessarily bad, the ability to achieve high organic growth without increasing leverage is always a plus. ROE does not take debt into account. (http://www.valuestockreports.com/030907.htm) (Stock Report, Sep 2007)

Northern Rock continued to develop diversified funding platform in 2006.New wholesale funding in 2006 reached £2.9 billion. Within these market NRK strong profile which meant that around 25% of the total was raised in private placement medium term note market.

3.2.18 Northern Rocks’ non retail wholesale fund provides short term and medium term fund with continued diversification of global investor base. In 2006 it raised $3.5bn of wholesale fund and raised another $2.0bn from US and Europe. (Company Reports, 2006)

3.2.19 Northern Rock used derivative instruments for reducing the risk of loss arising from changes in exchange rate and interest rates, these are used to hedge risk exposure. In 2006 the northern Rock has 1.36:1 liquidity gap cover for Asset v Liabilities. The year 2005 has the strongest liquidity cover of 1.52:1 compare to 1.19:1 to 2004. Liquidity ratio was one of compliant framework set by FSA, to ensure it is able to meet retail deposit withdrawals either on demand or at contractual maturity.

3.3 Profitability

3.3.1 The most obvious and important way of judging a company is by its profits and growth. Northern Rock’s Net interest Income showed a continuous growth of 23.26% (£1,016,80 m) in 2006 compared to 14.70%(£824.9m), as 89% of mortgage business in 2006 was sourced via the intermediary market, with 90% of this being conducted on-line for operational efficiency. We saw drastic increase of 8.36% to (£7,400m) in 2006 from (£6,829) 9% in 2005 of HBOS Net Interest Income.

3.3.2 Where revenue had risen by 23.6% in 2006 the operating expenses also rose by 11.26%, and was due to £81.2m of impairment loss on loan. The year 2005 and 2004 the growth in Revenue was almost equal to the growth in operating expenses for NRK, whereas HBOS raised in Trading Interest Income was 9% in 2005 whereas it’s operating expenses for that year rose by 7.40%, which shows its effective utilization of resources.

3.3.3  The gross profit Margin of Northern rock plc increased from 59.91% to 61.63%, also we saw rise in GPM of HBOS 20% to 44.54% in 2006. The increase in gross profit margin was due to be a positive growth in core market of Mortgages. The gross profit margin is not an exact estimate of the company’s pricing strategy but is does give a good indication of financial health. Withousan adequate gross maring, a company will be unable to pay its operating and other expenses and build for the future. It should not fluctuate much from one period to another, unless the A financial metric used to assess a firm’s financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. Gross profit margin serves as the source for paying additional expenses and future savings. (http://www.investopedia.com/terms/g/gross_profit_margin.asp).

3.3.4 The UK mortgage market continues to roar ahead in spite of the potential for rising interest rates with underlying lending up by a record amount.1 The HBOS appetite in market of mortgage was strong compared to Northern Rock as its net lending for 2006 was 58% as compared to the market growth of 20%.

3.3.5 Northern Rock’s showed a performance in respect of profit growth for attributable profit to S.H by 26.83% in 2006 from 12.86% in 2005. The HBOS claims that their strategy delivered strong performance in 2006 – 19% as compare to growth of 4.40% in 2005.

3.3.6 The Northern Rock continued to invest in people, systems and premises to support increased business volumes. Northern Rock expanded its e-business links with both intermediaries and direct customers. At the end of 2006, around 90% of all mortgage application was being submitted online, enhancing customer service and further improving cost efficiency. (Annual Report 2006).

3.3.7 The Cost to income ratio appears to be improved for both companies. We noticed HBOS controlled its cost more effectively, as its ratio improved from 44.70% (2004) to 39.30% compare to that of NRK which almost remained stable at 28.40%(2006) compared to 29.90%(2004).

3.4 Gearing Analysis

3.4.1 Gearing is the relationship between a company’s fixed return capital and its equity capital. The Northern Rock enjoyed lower gearing of 19.94 compared 26.92 of HBOS for 2006.

3.4.2 Over period of time its gearing climbed up from 14.43(2004) to 19.94(2006), which means it used external source of finance to fund its capital rather than using internal funds. The rise in debt would make the company vulnerable to external factors and it’s over reliance on economic condition. Any significant drop in foreign currency or interest rate could have worse effect on situation of Northern Rock.

3.4.3 Northern Rock; one of Britain’s fastest growing lenders at its peak, was virtually deteriorating when the wholesale market on which it depended on, to fund its mortgage lending dried up.

3.4.4 2006 was another year of record lending for Northern rock. Total gross lending was £33.0bn -22.67% higher than 2005. The HBOS’s lending remained about 21% compare to last year of 2005 – 21%. In the residential market the lending was 23% higher at £29.0bn which took Northern Rock to fifth largest mortgage lender by stock.

3.4.5 Clivie Briault (FSA head of retail division) said that the current turmoil should push boards to reconsider their business strategies. While Northern Rock was the lender most reliant on wholesale funding, most major UK mortgage banks are vulnerable, and Briault warned that some use retail funding which includes internet and other rate sensitive accounts that have proved to be increasingly fickle.

3.4.6 Northern Rock’s appetite for securitization, particularly in the U.S. and Europe remains huge. Its securitization book of £40.2 billion, representing 43% of total funding stock, launching of Granite program in 2006 the biggest ever single issue of £6.0bn completed in 2006 amounting total securitization to £17.8 bn. Whereas HBOS benefited from the increase in saving ration in U.K. and become the largest provider of saving products with an estimated share of 16% of Household Liquid assets Customer deposits rise up to 9% -£144.6bn from £132.2bn (2005).

3.4.7 Its liabilities in total continually climbed up to £79.933bn (26.98%) in 2006 from £62.949bn (31.40%) compared in 2005. NRK launches its Covered bond in 2004 to €20bn and raised €4bn from two benchmark issues.

3.5 Cash flow

Balance sheet shows historic information and is at one point in time at past. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable. (Wikipedia.org). There was a huge rise of 72.52% in cash & cash equivalent from 2004 in comparison to 2006 amount which was £1,046.60m but this showed a 3.67% decrease from 2005’s net cash & cash equivalent. The HBOS Cash & cash equivalent for 2006 was £8,191m – 41.35% less of last year which was £13,964m (2005).

The major cash outflow for NRK in 2006 compared to last two year was Loan and advances to customer which climbed 16.95% £17,005m (2006) compare to last year which was 18.46% increase £14,540m (2005).

The credit control appears to be compromised as there was 329% increase in net accruals from £49.7m(2005) to £213.4m(2006)

It’s imperative for a company to know whether the cash generated from its operations can meet its fixed liabilities and whether the company should go for investments using internal funds. In 2006 Operating cash flow was £2,358.1 and Outflow of investing activity was (£1,506.4) short of 1.56 times. It wasn’t able to fund itself internally in 2006 to meet its investing activities; it was compensated by proceeds from sale of securities of £2,157.7m. HBOS has 0.64 times short of meeting its investing activities and used last years opening cash & cash equivalent.

In 2006 its Cash from operating activities was declined almost 5.35% (£2,358.1) compared to 2005 (£2,491.6) which was an excellent year for NRK as it’s almost 700% increase from 2004 operating cash inflow amount £311.4m.HBOS saw a decline of 41% (£8,191m) in cash & cash equivalent compare to £13,964 – 2005.

3.6 SWOT Analysis

Strengths

Northern rock plc has the core business of provision of UK residential mortgages. The network consists of over 70 branches plus postal, telephone and Internet operations, with some residential mortgage business sourced through the UK financial intermediary market

The demand in housing enables to bring in revenue even in the case of rising interest rates and inflation.

Northern rock offered three new ISA and Fixed rate bonds in late 2007, which was indication of innovation and market research.

Weaknesses

3.6.4 Northern rock had limited range of mortgage product which can be a disadvantage in times, where rivals offering short term borrowing and first time buyer mortgage deals.

3.6.5 Reliance of funding over whole sale market is less attractive in terms of investment.

3.6.6 The cooperate Governance is not implemented as many of executive holds more than one position within the board.

Opportunities

3.6.7 There can be improvement in the margins by exploring ways of cutting down costs, thus improving profitability.

3.6.8 Contracting to a smaller, sustainable business through a reduction in the asset base of around a half by 2011, whilst maintaining a modest level of new loan origination.

3.6.9 Progressive repayment of the Bank of England loan and release of the Government guarantees over the next three to four years, while increasing the level of retail deposits to form a larger share of total funding.

3.6.10 The organisation restructuring and its operations so that these are aligned to the business objectives.

Threats

3.6.12 The boom in internet shopping over the years can further lower the company’s sales. Peoples could compare the mortgage deal of one company to other.

3.6.13 Market conditions remain uncertain and a protracted downturn in the housing market would clearly present challenges to its achievement. But we are testing it carefully across a range of scenarios and are confident that we can produce a plan that will be delivered.

3.6.14 Market moving towards recession and giving no chance for business to stand up which already suffered the bite of credit crunch.

The detouring housing prices could make it harder to introduce new deals with better margins.

Conclusion

A small regional bank that came from nowhere to head the competitive mortgage tables year in, year out over the last five years, it seems, had been surfing on a nasty rip tide, courtesy of the SIVs: some 80 per cent of its funding was bought ‘wholesale’ rather than from its own ‘retail’ customers. That 80:20 gearing allowed a small regional bank to play with the big boys whilst there was excess growth in the market, but spelled disaster on August 9th 2007, when the big boys ran out of their own liquid assets.(www.ft.com/articles on 31 March 2007)

Northern Rock should consider what liquidity and credit stresses would take it to the point of destruction, so that it can decide whether it is comfortable with what that implies about how they are currently positioning their business.

There are a few limitations of ratio analysis used for this project. The values from Balance sheet, Profit & loss & Cashflow upon which the ratio analysis was conducted are historic and at the year end. Therefore, does not represent an accurate analysis of the overall situation and profit doesn’t accrue evenly over a space of a time.

Furthermore, HBOS plc has a different Capital structure compared to Northern Rock and so is not perfect comparison cannot take place even though both operate in similar environments.

The covered bond were secured by a pool of ring fenced residential mortgages, to avoid the credit risk with these loans the risk were transferred into capital market by means of synthetic securitization transaction. The bonds were raised in Europe and US market, the credit crisis affected the value of bonds and the security against these assets worth less than the value of bonds. Northern Rock needed cash to support the investors and therefore got into financial trouble.

The Northern Rock gearing was increased persistently as it continued to fund through debt, the shareholder needs compensation for riskier investment so dividend per share was increased up to 20.3%. Irrelevant of profit made they should have compensated.

Mortgage market remains competitive and the Building societies converted banks like HBOS, Abbey Nationwide which were the big fishes and among them Northern Rock plc had put strong lending strategies appears from the growth which reaches up to 22% funding from external funding arm. Wholesale funds were raised for lending purpose.

4.0.9 Financial leverage determines how the “fruits of labor” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). (http://en.wikipedia.org/wiki/Leverage). Fruits of labour for Northern rock’s Revenue were shared up to 82.9% with interest payment for 2006 and its dividend paid out was 2.6% for the years.

4.0.10 Since June 2006, the interest rates had deteriorated with increase in Bank base rate and increase in money market swaps. The rapid increase in swap rates had a result of a negative drag on net interest income as fixed rate interest swap were transacted as mortgage lending was completed.

4.0.11 Northern Rock’s majority of funding was priced with reference to money market rates, the increase in LIBOR further lead to negative net interest rate spread, this impact was offset by realised gains on swaps resulted in redemption of underlying loans earlier.

The reason why the Northern Rock found itself in such trouble because the US market is a good example of a truly globalise nature of capitalism today. When the US sub-prime lending market took a dip, the previously confident banks stopped lending to each other. The Northern Rock relied upon borrowing from other banks to finance it’s lending in the forms of loans and mortgages, and Northern Rock plc built their lending business around their ability to borrow from other institutional lenders. Most of these lenders were not UK-based, and primarily American. So, when the “credit crunch” started to hit, NRK’s lines of credit dried up, and it was forced to go cap-in-hand to the Bank of England.

The run on the bank, which saw £2 billion withdrawn from branch-based accounts in the space of a week and an (as yet) unknown figure from postal based accounts, put a further strain on NRK’s capital base as well as its operating capital. Had existing savers left their money in Northern Rock, according to various finance pundits, it would have been in a more stable position to ride the storm. (Kit notes, Sep 2007)

4.0.14 The turmoil in the US subprime market also caused HBOS to take £227m of fair value adjustments on its Treasury assets through its profit and loss account. Andy Hornby, chief executive HBOS, said of the write downs: “We are not going to be complacent but this is low in comparison with many of our peers and our total exposure to US subprime is less than 0.1 per cent of our £667bn balance sheet.” (Jane Croft (Feb 2007) Retail Banking Correspondent)