Northern Rock, which surprised investors with a profit warning last month, plans share buy-backs of up to £400m over the next three years as it implements new banking rules, which stipulate how much capital it must hold.
The mortgage lender was caught out as it failed to anticipate the impact of rising interest rates, which have driven up the costs of wholesale funding. This will act as a drag on revenues in 2008. Interim pre-tax profits were flat at £296.1m (£293.9m).
The bank was unable to pass on more expensive funding to new borrowers because interest rates have not risen at the same pace. It was also caught out by not hedging the time between when a mortgage is taken out and when it is completed.
Adam Applegarth, chief executive, said the bank took a “deliberate decision” to step up its new mortgage lending because this would feed through into higher earnings by 2009 and 2010. The bank retains about 80 per cent of new customers when they come to the end of two or three-year mortgage deals.
“We made a decision to carry on lending, which will feed through ultimately into the earnings of 2009 and 2010,” he said. “We saw this as a land grab opportunity.” However he said the bank “could have done better” on hedging its exposure.
Mr Applegarth said he was “not worried” that Northern Rock was a takeover target .
“I don’t worry about it,” he said. “At the moment I don’t think minnows like Northern Rock are on anyone’s radar screen.”
Northern Rock said it had taken net new mortgage lending of 18.9 per cent in the first half against 14.5 per cent in the second half of 2006.
Northern Rock is adopting new Basel 2 banking rules. As a low-risk mortgage bank it needs to hold less regulatory capital and will release up to £400m for share buy-backs and will increase the dividend pay-out ratio.
Mr Applegarth said Northern Rock would continue to draw around 75 per cent of its funding from the capital markets although it was developing alternative sources of retail funding. It has launched a savings business in Denmark and Ireland and is looking to launch elsewhere in the Nordics.
The bank is to sell off part of its commercial loan book. The lender is also in talks about selling off its stand alone unsecured loan book to a third party.
Mr Applegarth said he expects house price growth to slow to about 4-5 per cent. He said interest rates are showing signs of hitting consumer confidence and volumes of housing transactions although this is being offset by consumers taking out larger mortgage loans.
Arrears continued to rise with residential mortgages three or more months in arrears up to 0.47 per cent from 0.42 per cent in December 2006. The Together secured product, which includes a mortgage and a loan, has seen arrears rise to 0.90 per cent from 0.84 per cent at the end of 2006. The number of properties in possession in the first half rose to 1,314, up from 662 at the end of 2006.
The net interest margin fell to about 68 basis points compared with 77 basis points for the full year. The bank expects the interest margin for 2007 to be above 60 basis points.
Impairment charges on unsecured loans almost doubled to £55.9m in the first half compared with £33.5m in first half of 2006. Almost 60 per cent of the charge in the first half related to IVAs and bankruptcies.
The interim dividend is 14.2p (10.9p) payable from earnings per share of 45.5p (45.1p).
Last month’s profit warning spooked the market and highlighted that Northern Rock’s reliance on wholesale funding carries some risks. Certainly the bank’s earnings growth in the next 18 months is likely to be more subdued and there will be a further squeeze on net interest margins, a key measure of profitability, which dropped to 68 basis points in the first half. However, prospects for the longer term look much better. Northern Rock will benefit from share buy-backs and will see earnings bolstered as it retains more new customers. The shares may also benefit from speculation that Northern Rock will be a takeover target. Collins Stewart puts the bank on 8.2 times 2008 earnings, which seems reasonably priced.